|Submission No. 5||Back to full list of submissions|
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REVIEW OF BUSINESS TAXATION
FIRST DISCUSSION PAPER
A STRONG FOUNDATION
1. Inadequate response to taxation of international income flows
Revenue protection means that the government is faced with a choice of tax policies to maximise national welfare, subject to a budget constraint. This goal can be achieved by minimising distortions on investment decisions. Domestic neutrality is important, but the primary issue is how does a particular investor respond to the level of tax burden, because this determines the magnitude of tax revenue. To minimise distortions, it must be important to evaluate the elasticity of responses by agents to the tax burden. This is difficult to quantify, so it should be part of the art of taxation rather than a science.
Globalisation of investment arguably increases the elasticity of response to national tax burdens. The document notes that globalisation heightens the urgency of reform (point 11 in the overview). Globalisation raises the premium on efficient business tax arrangements and it will offer companies additional scope in their choice of national base so that international differences will play a greater role in that choice. It is disappointing that broad policy responses to these challenges are absent from the A New Tax System (ANTS) document and this first discussion paper.
This issue lies at the heart of the conflict between ‘economic growth’ and equity objectives. Policies to achieve investment neutrality with respect to domestic investors may be in conflict with neutrality for international investors. For example, a policy to ensure that all domestic business entities are taxed in the same fashion may lead to higher tax burden relative to treatment of comparable entities overseas.
As a result, the level of taxation on cross-border income flows must also enter into investment neutrality principle. While this issue is noted in Principle 9, it goes much deeper than this principle identifies. Treatment of international income flows is the root of much of the increased complexity of the business tax system (for example, franking credit trading provisions, anti-streaming provisions and exempt foreign income provisions).
Principles for international investment income neutrality are not simply to encourage competition by reducing tax burdens - on the contrary, there should be broad agreement on the tax principles. By the same token, Australia should not unilaterally introduce policies that increase the tax burden - because this too could result in an erosion of tax revenues without any benefit in terms of greater investment. This principle must be given more attention, because it may be violated by policies that achieve purely domestic neutrality principles.
To pursue international neutrality, our taxation principles should be shared by governments of our major trading partners. Australia should not pursue these principles without making efforts to influence overseas tax treatment of income flows into and out of Australia. This goal is not simply a matter of pushing to have other countries recognise our increased taxation, which would lead to increased tax burden on offshore income that we earn. It should attempt to reduce the double (or more) taxation of investment income. Negotiation of lower cross-border income taxation through Double Tax Agreements should be given the same prominence as domestic investment neutrality, due to (not in spite of) the difficulty of achieving such reform.
In this respect tax policy is not analogous to tariff competition (as suggested on page 26). Tax policy operates with a basic budget constraint, and the size of this constraint and the range of policy instruments can differ between countries. If governments become more efficient, then a smaller budget constraint can mean that taxes are lower and welfare is greater. This is a worthy objective, which reflects the fact that lower taxes can be a manifestation of a more efficient economy.
Similarly, governments should evaluate how to optimally raise tax revenue, and lower taxation of mobile capital is a valid option for increasing national welfare. In fact, this point is recognised in its offshore banking unit policy, where exemption from interest withholding tax ‘reflects the view that Australia does not have a strong claim for taxing that income’ (Tax Expenditure Statement 1996-97, page 62), and the foreign dividend account policy. These policies reflect the fact that tax policy competition is not necessarily analogous to tariff competition.
2. International taxation is also a basic source of complexity (Chapter 3)
ASX agrees that the sources of complexity require a response, particularly in regard of differentiated taxation of entities and investments and policy framework.
But taxation of international income flows (as noted above) is the root of much tax law complexity, contributing to the problem areas identified in the paper:
Principles on taxation of international income might address a significant number of the complexity issues identified, which may lead to examination of numerous policy solutions other than those proposed in the document. The Review paper on international taxation systems should be a valuable source of policy options.
In particular, the discussion of Policy Design Principle 7 (Investment Neutrality) must take account of double taxation of income from cross-border investment. There are no policies identified which would attempt to reduce this bias, which is very disappointing as the Review specifically argues that globalisation raises the premium on efficient business tax arrangements.
3. Policy design principles
Principle 2 - Comprehensive Income Taxation (CIT)
The discussion of CIT identifies a number of current exceptions that are expected to persist if this principle is pursued. The paper does not, however, assess whether these exceptions hobble the CIT principle, such that its application yields a more biased outcome than if the current system is maintained.
There are some aspects of the CIT principle that are not addressed in the discussion paper. For example, the current asymmetric treatment of equity and debt finance costs is not discussed, and the status of income and costs attributable to foreign activities is not analysed. Application of CIT to these issues must be thoroughly examined, because this analysis will contribute to consideration of other principles, such as the Integration of Ownership Interests (Principle 4) and Investment Neutrality (Principle 7)
Asymmetry of economic gains and losses
The Discussion Paper identifies CIT as an important principle, but then notes that a number of structural reforms of the current tax system would be necessary to achieve this goal. The paper notes that some reforms are possible to move towards this goal, but that the asymmetry of treatment of economic gains and losses would persist. The Review must establish whether this non-neutrality introduces significant biases to investment decisions that undermine the objective of the CIT principle. In particular, does implementing CIT with this major non-neutrality bias investment such that there is lower economic growth than if the current system is retained ? For example, this asymmetry is likely to bias investment away from long-term investment, where economic losses are incurred in the early years of production.
Equal treatment of debt and equity costs
There is a major departure from CIT under existing arrangements that is not mentioned in the discussion paper. As business finance costs, equity and debt are not treated equally. The cost of servicing debt is deductible, so it conforms with the CIT principle. But the cost of servicing equity, in the form of dividend payments is not deductible, which violates the CIT principle.
This inequitable treatment of business finance costs should be given prominence in discussion of the CIT principle. The discussion paper does not adequately explore biases arising from the inequitable treatment of equity and debt. In particular, the legislative complexity arising from treatment of debt differently to equity must be acknowledged. For example, detailed proposals for the Taxation of Financial Arrangements are founded the distinction between debt and equity.
The Government’s deferred company tax (DCT) proposal could exacerbate the distortion between tax treatment of the costs of equity and debt for globalised companies. Under DCT, taxation on dividends paid to non-resident shareholders would be increase to the corporate rate of 36 per cent. In contrast, interest costs paid to non-residents would only bear an interest withholding tax, typically at a 10 per cent rate. This bias would create incentives for some companies to switch to foreign debt finance by reducing dividends paid to Australian and foreign investors. It would mean higher gearing for Australian global companies, due to the distortion of taxing equity finance costs differently to debt finance costs.
If the CIT principle is to be pursued, the Review must analyse ways to align the tax treatment of finance costs. There appear to be two paths that might be followed. First, both debt and equity costs are made deductible, which would be most consistent with the CIT principle. This approach would, however, significantly reduce taxation of equity income earned by non-residents. Second, neither equity nor debt costs are deductible, but franking credits are distributed with payments of both costs. These options should be thoroughly explored when the Review evaluates means of implementing the CIT proposal.
Without efforts to achieve equality in the treatment of business finance costs, the CIT proposal will not achieve the neutrality and legislative simplification goals that the government aspires to.
Treatment of foreign-source income
The Discussion Paper does not discuss how the CIT principle should be applied to taxation of foreign-source income. It is vital that the application of this principle to foreign-source income is clearly established, because Australia is a small economy with companies that will rely on offshore profits and access to foreign capital for growth.
As part of this analysis, the Review should examine the double taxation of foreign-source income. Double taxation arises when the income is taxed overseas (by corporate and withholding taxes) and then by personal income taxation in the hands of Australian residents. ASX notes that some countries do not impose domestic taxes on foreign-source income, which means that such income only incurs one level of (foreign) tax. Differences arise because of the lack of integration of company and individual taxes across countries. The Review should establish whether the CIT boundary should extend to foreign-source income, by evaluating whether Australia benefits by reducing double taxation of foreign-source income. This analysis would consider our policy in the context of the potential for reciprocal reduction of tax on Australian-source income earned by non-residents.
The current system does not tax all offshore profits earned by resident companies. There are exemptions provided for profits from some countries. This arrangement can make it difficult to adequately account for costs incurred in the process of generating profits overseas. For example, interest costs incurred in Australia that are attributable to creation of exempt foreign profits may not be tax deductible in Australia. The Review should establish how the principle of CIT applies to foreign-source profits, and why profits from different sources are treated differently for tax purposes.
Another difficult issue is the taxation of foreign source profits that earned by an Australian company, and subsequently partly distributed to non-resident shareholders Such profits are known as ‘conduit’ income.
If an Australian company has foreign shareholders, then it may distribute some of its offshore dividend back overseas. In effect, the offshore dividend passes through Australia - it can be called pass-through income. While unfranked dividends are ordinarily subject to withholding tax when they leave Australia, there are special tax exemption provisions for pass-through income. When relevant offshore dividends are earned, the Australian resident company notionally adds to its foreign dividend account. If the account is in surplus and the company wishes to pay an unfranked dividend to a non-resident shareholder, then the pass-through dividend is exempt from Dividend Withholding Tax.
While these provisions might appear to allow for all pass-through income to be exempt from any Australian tax, the system does not always deliver this outcome. The reason is that exempt offshore dividends are pooled with after-tax franked Australian dividends prior to distribution to shareholders. This results from rules that prevent the streaming of the foreign dividend account to foreign shareholders.
For example, take an Australian company that has equal numbers of resident and non-resident shareholders, and assume it earns a pool of 50% fully franked Australian source dividends and 50% offshore dividends (that are exempt under the foreign dividend account rules). Each shareholder receives a distribution out of Australian source dividends and offshore dividends, which means that some of the exempt offshore dividends are taxed in the hands of resident shareholders. Similarly, non-resident shareholders receive some franked Australian-source dividends, but they cannot fully use the franking credit (recall that the credit offsets Dividend Withholding Tax).
This outcome means that the franking credits attributable to Australian corporate tax diminish in value as a company become more globalised. In essence, the tax system penalises successful Australian companies, by inadequately distinguishing Australian source income from foreign source income.
The proposed business entity taxation system could exacerbate the bias associated with the taxation of foreign source income. As described above, certain types of foreign source income are not taxed in Australia, so they may be distributed as unfranked dividends to resident and non-resident shareholders. It appears that deferred company tax would be levied on all unfranked dividends, including those sourced from FSI. This would add a layer of tax to such dividends, significantly penalising non-resident shareholders.
It is expected that a corollary policy will be recommended to avoid this outcome. The ANTS document (p. 118) notes a policy goal is that "… the Australian tax system does not unduly impede offshore income passing through Australia to non-residents (‘conduit income’)…". There are a two ways that the FFIS could be implemented to avoid it imposing an incremental burden on conduit income:
The Review should establish how the principle of CIT applies to ‘conduit’ income, before considering how such income might be treated under the DCT proposal.
Treatment of Australian-source dividends distributed by non-resident companies
An important area where current provisions are inconsistent with Principle 5 (a single layer of domestic taxation) is the taxation of non-resident companies. Non-resident (foreign) companies pay Australian tax directly themselves or indirectly through their Australian subsidiaries. Yet dividends paid by a foreign company to Australian shareholders do not qualify as franked dividends. This means that there are two levels of taxation of income paid to resident shareholders by foreign companies.
A resident and non-resident company paying the same rate of tax will generate very different after-tax rates of return for an Australian shareholder. This is clearly an inequitable situation for investors, which biases investment decisions. To be consistent with the principle of imposing a single layer of taxation, the government should allow foreign companies to pay franked dividends to resident shareholders in the same fashion as resident companies.
Capital gains tax
It is vital that the CIT principle distinguishes income flows from exchanges of capital by businesses. Where there is a reconstitution of capital that does not generate income, the CIT principle implies that this transaction should not be taxed.
In this respect, the ANTS proposal to extend capital gains tax rollover provisions to scrip-for-scrip transactions is a step in the right direction. There is also potentially positive outcomes in recommendations for reform of share buybacks and liquidations. In particular, the Review must address the double taxation that occurs when a company buys back shares for cash.
The CGT implications of splitting a company into several entities is another dimension of this issue. As this action is simply a reverse of a scrip-for-scrip transaction, it is arguable that CGT rollover provisions also be extended to corporate de-mergers. This policy would lend symmetry to the CGT treatment of corporate restructuring.
Business entity taxation system
It is vital that the business entity taxation system is carefully evaluated in terms of its components and their relationship to the principles outlined in the Discussion Paper.
The main components of the proposal are:
While a component of the business entity system may achieve outcomes that are consistent with a given principle, this must not be the sole basis for recommending that policy. Each component of the business entity taxation system should be analysed separately using a cost-benefit framework. The Review’s recommended policies must be established as the best choice from a menu of possible policies for a specific principle.
The business entity system (as outlined in ANTS) is identified in the Discussion Paper as a means of achieving desired results for a number of policy design principles:
ASX is strongly supportive of these principles, but notes that the Discussion Paper does not mention policies that are individually consistent with each principle, other that the proposed Business Entity Taxation system identified in ANTS. The Discussion Paper notes that the proposed Business Entity Taxation system would achieve goals for each principle. While the Discussion Paper does not seek to establish policy for achieving objectives for each principle, the Business Entity Taxation System is consistently mentioned as a likely policy reform.
As the Business Entity Taxation system comprises several parts, it is uncertain which element is recommended as a means of addressing identified goals. It is important that the Review fully considers the possible implications of each principle, rather than pursuing interpretations that are consistent with the Business Entity Taxation system. In particular, treating business entities equitably does not imply treatment as companies; nor should it imply that all entities are taxed at the highest rate for any one type of entity.
Taxing all business entities as companies
In respect of Principle 4 (‘Integration of Ownership Interests’) and Principle 7 (‘Investment Neutrality’), there is limited discussion of the reason for adopting taxation of income at the entity level rather than at the individual level. There appear to be two key impediments to taxing income purely at the individual level:
Primarily for these reasons, a combination of business entity and individual taxation is adopted in most countries.
ASX acknowledges that investment neutrality requires all income generated by business entities to be taxed in the same manner. One element of the proposed business entity taxation system is directed to this neutrality goal: taxation of trusts, life insurers, co-operatives and limited partnerships as companies.
Taxation of all entities as companies lends the negative features of company taxation to trusts, life insurers, co-operatives and limited partnerships. For example, the distribution of untaxed income by a trust to a beneficiary avoids a level of administration in the taxation system. This outcome is particularly important for unit trusts, where there is a multitude of beneficiaries.
It is important, therefore, that the Review clearly demonstrates how the current treatment of trusts, life insurers, co-operatives and limited partnerships distorts investment decisions, before recommending that all entities be taxed as companies. It may then be possible that some distortions can be reduced without taxing a trust (or other entity) like a company.
For example, if the tax-free distribution of tax preferred income by a trust is found to be a source of distortion, then amendments to particular provisions could be made to prevent tax-free distributions. This analysis will depend on the desirability of maintaining tax preferences, which is a separate issue for the Review. If a preference is considered to be worthwhile, then a possible outcome might be that tax preferences are distributed as tax-free income by all business entities. This outcome would be consistent with investment neutrality principle applied to treatment across entities.
Hence, it is important that equity not be seen to imply that all effective tax rates are raised to the highest level for current entities. This is the expected outcome from the ANTS document, where the taxation of trusts and life insurers as companies is expected to raise almost $4 bn in revenue over four years to 2002-03. An equity principle could equally mean that effective tax rates for some entities are lowered.
For this reason, the Review should document the precise sources of distortions in the taxation of business entities, and evaluate a number of policy reform solutions against the principles outlined in the Discussion Paper. This evaluation should take into account the bases for preserving of tax preferences, as proposed in the Review.
Changing the Definition of Company Taxation - Deferred Company Tax
The proposed business entity taxation system does more than recommend that all business entities be taxed as companies. The deferred company tax (DCT) element of the business entity taxation system significantly changes the current definition of company taxation. It is one thing to argue that business entities should be taxed in the same manner; but the proposal goes much further by changing the definition of business entity taxation.
The purpose of the deferred company tax proposal appears to be clawing back of tax preferences. Tax preferences may mean that a company pays unfranked dividends to shareholders, but deferred company tax would be required to be paid on unfranked dividends. In the case of trusts, some tax preferences are distributed tax-free to resident beneficiaries. In essence, the DCT claws back some of the intended tax preference.
The extent of claw back differs between resident and non-resident shareholders. Resident shareholders are already subject to claw back of preferences that flow as unfranked dividends, as they incur a higher marginal tax on such dividends than on franked dividends. Non-resident shareholders are currently subject to dividend withholding tax on unfranked dividends. This means that the marginal tax burden on unfranked dividends paid to non-resident investors will increase significantly as a consequence of the DCT proposal. The ANTS document estimates that the DCT for companies will raise about $400 million, primarily from non-residents. ASX estimates that this is equivalent to raising the corporate tax rate from 36 per cent to 40 per cent under the prevailing tax system (after accounting for franking rebates in the hands of resident shareholders).
In this context, the possible inconsistency of outcomes across principles will be thoroughly examined. For example, the impact of some components of the business entity system must be carefully analysed in the context of Principle 9 (Balanced taxation of international investment). There is little point in having a more neutral domestic system if the overall tax burden on business is raised in comparison with other countries, which would result in a greater tax wedge compared to returns from investment in other countries. Accelerated depreciation is the dominant tax preference by value, but its provision is common in OECD countries. Effectively removing accelerated depreciation would greatly reduce the competitiveness of Australian companies, thereby constraining our economic growth.
For these reasons, analysis of tax preferences must be undertaken in conjunction with evaluation of the business entity taxation system proposal. The Review notes, however, that there are grounds for maintenance of tax preferences, where a set of criteria are met. There is a conflict, however, between the recommendation for the business entity tax system and provisions for tax preferences. In particular, the desirability of maintaining some preferences appears to conflict strongly with introduction of deferred company tax. Lowering the entity tax rate is a potential solution to this conflict; but as the Review notes, this step would raise new problems by increasing the misalignment of the entity tax rate with marginal rates of personal taxation.
In this respect, the Review must take account of the pervasive interaction between policy proposals. The Review must acknowledge the inherent biases in its proposals for comprehensive income taxation and business entity taxation. To allow the Review to address conflict between principles, maintenance of a current tax policy should always be on the menu, to ensure that reforms do not compromise outcomes for particular investors. It is preferable that a set of alternatives be fully evaluated for all principles. For example, there are numerous options for investment neutrality:
Analysis of options should be undertaken in a cost-benefit framework, with public scrutiny of the assumptions and data used to undertake this analysis.
In summary, ASX recommends that the business entity taxation system is unpacked and evaluated as a set of separate policies against alternatives including status quo options. It should be acknowledged that achieving equitable tax treatment across business entities does not imply the raising of all effective tax rates to the highest rate for an entity. A lower effective tax rate is also consistent with investment neutrality.
In terms of the deferred company tax proposal, the Review should then establish whether a higher effective tax rate across all business entities benefits the Australian economy, using a cost-benefit analysis that incorporates the contribution of tax preferences to economic activity. This analysis will take into account the need for investment neutrality across countries, in terms of the response of business entities to choosing where to maintain business activities.
4. Revenue neutrality ?
The Discussion Paper states that the ‘reforms to the system will need to be conducted against that baseline in a revenue-neutral setting’. The terms of reference note a revenue-neutral setting for evaluating a lower rate of corporate tax against taxation of business investment income, but specifically excludes the business entity proposals. ASX therefore assumes that the evaluation of the business entity proposals is not being undertaken in a revenue neutral framework. That is, changes to the taxation of business entities may increase or decrease the level of revenue derived.
In terms of policy changes that are to be conducted within a revenue-neutral framework, the Review must be careful to thoroughly evaluate the policies that might contribute to the revenue neutral outcome. Valuation of tax burdens can be very complex in imputation systems. For example, the imputation system will lead to taxation of tax-preferred income in the hands of resident shareholders. Similarly, a reduction in corporate tax will shift primarily shift the incidence of tax from the company to resident shareholders.
This situation means that revenue neutrality can only be properly undertaken once evaluation of the business entity taxation system is made. The Review should consider the FFIS proposal before considering the revenue neutrality of proposals (as described in the terms of reference).
The Discussion Paper does not address these issues. Given the importance of achieving a set of revenue neutral recommendations, the Review must provide detailed methodologies that will be applied to value the revenue implications of specific policies. It should publish the assumptions made for each calculation, identify disaggregated estimates for each policy proposal and note interactions between proposals. This approach is vital to ensuring that changes to the domestic tax system result in revenue neutral outcomes as required by the Review’s terms of reference.