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Submission No. 11 Back to full list of submissions
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National Farmers' Federation

First Submission to the Review of Business Taxation

December 1998

Prepared by

Robert Douglas

Director, Rural Policy

Contents

Executive Summary

1. Introduction

2. The Appropriate Business Tax Base

3. Taxation and Risk

4. Assessment Periods and Measures to Alleviate Period Inequity

5. Entities Taxation

6. Transition Measures

Executive Summary

The National Farmers' Federation (NFF) believes that the Review’s A Strong Foundation is a welcome addition to the tax debate in Australia, and has the potential to lead to major changes to business taxation. NFF supports the Review’s National Objectives for business taxation. NFF believes that there is a need for a further specific objective ensuring that the business taxation system encourages international trade and the export of Australian goods and services.

NFF is concerned that the Review is not interpreting its Terms of Reference (TOR) sufficiently broadly. NFF believes that the TOR require the Review to commence its activities by defining a comprehensive framework for business taxation. The Review is charged with making a critique of existing business tax arrangements, and recommending enhancements that may well be outside the existing paradigm.

NFF believes that the Comprehensive Income Tax (CIT) base is inappropriate for business, and that the Review should consider the Expenditure Tax (ET) as an appropriate business tax base. This is because the CIT was designed as a personal tax base – not a business tax base – and its designers admit its implementation would have a distinctly adverse effect upon the size of the national income.

It has been said that an Income Tax taxes what a person brings to society, while an Expenditure Tax taxes what a person takes from society. A move to an ET would be consistent with the Government’s proposals to introduce a broad-based consumption tax.

The choice between moving closer to a CIT or an ET base should be influenced by the tax systems of Australia’s trading partners. While other countries tax systems are like Australia’s – a hybrid between a CIT and an ET – it would be imprudent for Australia to be move closer to a CIT base if the international tend is to an ET base, or vice versa. Substantial differences between Australia’s tax base and those of our major competitors can make it more difficult for Australia’s exporters to compete on international markets and may act as a deterrent to foreign investment. Such differences could make it more difficult to prevent taxation of the same transactions in more than one country.

In particular, the NFF believes the Review should address these issues:

    • Which tax base is most likely to optimise growth in the Australian economy?
    • Are Australia’s trading partners more likely to move towards a CIT or an ET over the next decade?
    • What would be costs and benefits of Australia moving closer to a CIT or an ET?
    • What transition or compensation measures would be appropriate under each proposal?
    • Who are the ‘winners’ and ‘losers’ of each proposal? and
    • What would be the tax expenditures under each proposal?

The Review should undertake, or commission, research to estimate the relative deadweight losses of taxing labour and capital. If the deadweight loss of taxing capital is substantially more than that of taxing labour (as some US research suggests), NFF believes there would be a compelling case to move closer to an ET. Alternatively, if the Review chooses to move closer to a CIT, tax rates on capital should be reduced.

NFF believes that it is essential to include measures to alleviate period inequity, the additional tax burden associated with fluctuating incomes, within the benchmark tax base to be proposed by the Review.

NFF is strongly opposed to proposals to tax trusts as companies. NFF believes the correct position should be for companies to be taxed as trusts. Taxing trusts as companies could lead to the collection of more tax at entity level than will be required at final assessment, forcing the small business sector to make a permanent loan to Government.

Should the Government persist with proposals to tax trusts as companies, NFF believes that many small businesses will find that their existing trust structure would become inappropriate for their business. Such businesses should be offered a ‘window of opportunity’ to move to a more appropriate business structure free of capital gains tax and State stamp duties, with all legal and accounting fees compensated by Government.

NFF believes that the tax system should not act to discourage risk takers from adopting long term risk. The Australian tax system discriminates against risky investments. The tax system is the major mechanism where society shares the benefits and risks of investment. NFF is unaware of any Australian research that quantifies the effect the tax system has on risk taking and recommends that the Review undertake appropriate research.

One practical method of removing the discrimination against risky activities inherent in the Australian tax system would be to introduce a system allowing for losses of the current year to be offset against the profits (if any) of the previous three years. This would allow refunds of taxes paid in those earlier years.

NFF also welcomes the Review’s suggestions for an improved policy development process. For too long, tax policy development in Australia has been conducted in secret. Improved consultation with industry should lead to better tax policy.

1. Introduction

The National Farmers' Federation (NFF) welcomes the opportunity to make a submission to the Review of Business Taxation. NFF has long championed the cause of tax reform in Australia, and has advocated the introduction of a broad-based consumption tax since 1988.

NFF believes that the Review’s A Strong Foundation is a welcome addition to the tax debate in Australia, and has the potential to lead to major changes to business taxation.

However, NFF is concerned that the Review is not interpreting its Terms of Reference (TOR) sufficiently broadly. The Review is specifically charged with:

… including an assessment of the design and administration of the tax regimes affecting business to identify their main shortcomings and their impediments to productive activity and innovation.

The Review will make recommendations on the fundamental design of the business tax system, …

These TOR allow, indeed demand, that the Review commence its activities by defining a comprehensive framework for business taxation. The Review is charged with making a critique of existing business tax arrangements, and recommending enhancements that may well be outside the existing paradigm.

NFF supports the Review’s National Objectives for business taxation – optimising economic growth, ensuring equity and facilitating simplification. If the Review can meet these objectives, it will make a major contribution to the economic well being of Australia.

NFF recognises that the first of the Review's national objectives - ‘optimising economic growth’ - is wide and would embrace the concept of international competitiveness. Nevertheless, NFF believes that enhancing international competitiveness is of such importance to Australia's economic prosperity that the objectives should specifically address the need for a taxation regime that encourages the international competitiveness of Australian business and Australian exports.

NFF also welcomes the Review’s suggestions for an improved policy development process. For too long, tax policy development in Australia has been conducted in secret. Improved consultation with industry should lead to better tax policy.

Similarly, the proposed changes to the administration of the tax system are also welcome, and the proposed Charter of Business Taxation would assist in facilitating improved tax administration.

The most important aspects of A Strong Foundation are the proposed policy design principles. Here again NFF agrees with much of what has been proposed. Business entities are undoubtedly the extension of their ultimate owners, and a single layer of tax should be applied in the hands of those ultimate owners. The tax system should not distort the choice between risky and safe investments, and the existing impediments to risky investments should be removed. NFF policy calls for the abolition of Fringe Benefits tax and the taxing of fringe benefits in the hands of the beneficiary.

However, NFF strongly disagrees that a Comprehensive Income Tax (CIT) base is an appropriate base for business taxation. This is because the CIT was designed as a personal tax base – not a business tax base – and its designers admit its implementation would have a ‘distinctly adverse effect upon the size of the national income’. NFF urges the Review to examine the alternative Expenditure Tax (ET) proposals as a suitable business tax base, and notes the cautious support of US Treasury for such a change.

The remainder of this submission is set out as follows. In the next section, arguments are advanced in support of an ET base rather than a CIT base. It is recommended that the Review attempt to quantify the costs and benefits of moving towards either base. This is followed by a brief discussion of economic reasons why a schedular tax system could be used.

In the third section, the discrimination of the Australian tax system against risky investments is discussed. It is recommended that the Review attempt to quantify the effect of that discrimination on the Australian economy. NFF believes that the tax system should not act to discourage risk takers from adopting long term risk, rather it should encourage the undertaking of risky projects that are likely to increase national wealth.

In the fourth section, it is shown that the concept of equity for business taxation demands steps that ameliorate period inequity - the additional tax imposed on variable incomes compared to more stable incomes.

In the penultimate section, it is demonstrated that an attempt to tax trusts as companies lacks a theoretical basis, and will impose a large additional tax burden on small business. NFF strongly opposes this proposal. Entities taxation should not be extended to the family farm. There are legitimate reasons having little to do with tax for choosing to hold the family's most significant asset in particular business structures. If these objectives are to be made prohibitively expensive to secure because of major changes to the taxation of trusts, NFF calls on the Government to grant a ‘window of opportunity’ for farmers to restructure their affairs. The ‘window of opportunity’ would allow existing trusts to divest their assets to the underlying owners free of capital gains tax and State stamp duties. The Government should provide compensation for all necessary legal and accounting charges.

In the final section, the need for suitable transition measures will be discussed.

2. The Appropriate Business Tax Base

NFF welcomes the commitment of the Review of Business Taxation to undertaking the review with reference to a cohesive framework. In conducting such a review, it is essential to have the foundation of a reference tax base from which it will be possible to examine the existing tax provisions.

There are two theoretical tax bases that are commonly used as reference bases, the Comprehensive Income Tax and the Expenditure Tax (or cash-flow tax). The main difference between these two bases is that the former includes savings in the base; the latter excludes savings. The former depreciates investment; the latter expenses it. It has been said that an Income Tax taxes what a person brings to society, while an Expenditure Tax taxes what a person takes from society.

In examining the two bases, it is useful to understand their historical backgrounds. An income tax (as a temporary tax) was first introduced in Britain to fund the Napoleonic wars 200 years ago. Care was taken at that time not to tax capital, as this would have lead to double taxation because most tax revenue at that time was derived from the taxation of capital. As taxes on fixed capital have declined over time, the challenge has been the inclusion of capital into the income tax base.

Henry Simons defined the modern Comprehensive Income Tax base in his 1938 book Personal Income Tax. Simons drew on earlier work of R M Haig and Georg Schanz.

It is important to remember that Simons was writing at a time when income taxes collected less than five per cent of the total taxes collected in the USA. Simons’ motivation in writing his book was to substantially increase income taxes with an aim of reducing income inequality.

Simons’ goal certainly was not economic growth. To the contrary, Simons accepted that his proposal would substantially reduce economic growth:

Two simple points should be noted at the outset. First, the effect of a higher degree of progression in taxation upon the distribution of income is certain; the effect on production, problematical. One is a matter of arithmetic; the other, largely, of social psychology. Second, if reduction in the degree of inequality is a good, then the optimum degree of progression must involve a distinctly adverse effect on the size of the national income. Prevailing opinion notwithstanding, it is only an inadequate degree of progression which has no effect upon production and economic progress (p 19).

The Progressive Expenditure Tax was first proposed by Nicholas Kaldor in 1955, and further developed by the Meade Committee in 1978. Meade concluded:

There are serious difficulties in defining an individual’s income satisfactorily for tax purposes and in particular in finding the appropriate treatment for windfall receipts and for different kinds of capital gains. Taking expenditure on consumption in place of income as a tax base raises less acute problems of definition; it taxes what a person takes out of the economic production system rather than what he puts into it; it combines greater opportunities for economic enterprise with heavier levels of taxation of high levels of consumption financed out of the dissipation of wealth; and it avoids problems arising from the distinction between earned income and investment income. On the other hand it may involve somewhat higher rates of tax.

In 1975, the United States Treasury was asked to propose methods on simplifying the US income tax system. Their report, Blueprints for Tax Reform, was published in 1977. The report examined the consequences of moving to both CIT and ET bases. The report cautiously supported an expenditure tax:

The report shows that a version of the consumption base tax, called the ‘cash-flow tax’, has a number of advantages over a comprehensive income tax on simplicity grounds. The cash-flow tax avoids the most difficult problems of measurement under a comprehensive income tax – such as depreciation rules, inflation adjustments, and allocation of undistributed corporate income – because all forms of savings would be excluded from the tax base.

In addition, the report demonstrates that the cash-flow tax is more equitable because it treats alike all individuals who begin their working years with equal wealth and the same present value of future labor earnings. They are treated differently under an income tax, depending on the time pattern of their earnings and the way they choose to allocate consumption expenditures among time periods.

By eliminating disincentive to saving, the cash-flow tax would encourage capital formation, leading to higher growth rates and more capital per worker and higher before tax-wages.

Some differences between the two bases are shown in Table 1 (based on Blueprints for Tax Reform).

 

Table 1

A Comparison of the Current Income Tax, a Comprehensive Income Tax

and a Progressive Expenditure Tax

Item

Current Income Tax

Comprehensive Income Tax

Progressive Expenditure Tax

Retained Corporate Earnings

Separately taxed to Corporations

Separately taxed to Corporations

No tax until consumed

Corporate dividends

Fully taxed, imputation credits allowed

Fully taxed

No tax until consumed

Capital Gains

Real gains taxed on realisation

Nominal gains taxed on realisation

No tax until consumed

Capital losses

Deductible against capital gains only

Immediate deduction

No deduction unless reduced consumption

Trading stock valuation

Choice of cost or market values

Market value

Not included

Depreciation

Complex rules for classes of structures and equipment

Reformed rules allowing for reductions in economic value

Permits expensing of all business outlays

Interest received

Taxable

Taxable

No tax until consumed

Proceeds of loans

Not taxable

Not taxable

No tax until consumed

Interest paid on loans

Deductible to business

Deductible to business

Deductible to business

Principal Repayments

Not deductible

Not deductible

Not deductible

State and Local taxes

Deductible to business

Deductible to business

Deductible to business

Superannuation contributions

Partially deductible

Not deductible

Fully deductible

Superannuation funds earnings

Taxable under special rules

Taxable

Not taxable

Superannuation benefits

Partially taxable

Partially taxable

Taxable unless saved

Social welfare payments

Taxable (some exempt)

Taxable

Taxable unless saved

Salary and wages

Taxable

Taxable

Taxable unless saved

It is well known that the current Australian income tax system is a hybrid between an income tax and an expenditure tax. There is little doubt that greater simplicity will be achieved by moving closer to either theoretical base. However, it is unlikely that either theoretical base could be practically implemented in full.

To some extent, the choice between moving closer to a CIT or ET base is dependent upon the tax systems of Australia’s international trading partners. Other countries’ income tax systems are like Australia’s – a hybrid between the CIT and ET. An important question is whether overseas tax systems are moving closer to the CIT or ET base. It would be imprudent for Australia to be moving closer to a CIT base if the international trend was to an ET base, or vice versa.

As the trend towards a global market gathers pace, it becomes increasingly important to consider Australia’s tax system in light of those of its major competitors. Taxation influences economic decision-making and distorts the allocation of resources. These distortions become direction setting any inequities are minimised to the extent that all participants in a "market" face the same tax liabilities. Substantial differences between Australia’s tax base and those of our major competitors can made it more difficult for Australian exporters to compete on international markets and may also act as a deterrent to foreign investment in Australia’s much smaller market. It is imperative that the tax system facilitates international trade and encourages exports.

Further, Australia’s international trade is dependent on International Tax Treaties that attempt to prevent taxation of the same income by more than one country. Coordination of the Australian tax base with our trading partners will make it easier to avoid double taxation and encourage international trade and investment.

In 1997, the Congressional Budget Office of the Congress of the United States published The Economic Effects of Comprehensive Tax Reform, which examined five new tax bases proposed for introduction to the USA. It is noteworthy that only one of the five new bases examined proposed depreciation of capital investment, the others proposed immediate expensing. This suggests that tax reform in the US is more likely to move to the ET base than the CIT base.

In attempting to achieve its national objective of optimising economic growth, it is important that the Review examines both theoretical bases to determine which is most likely to achieve this goal.

A further point in favor of an ET is that it is more likely to assist the Government in meeting its Environmentally Sustainable Development objectives. This is because expenditure for environmental purposes can be considered investment in the future of Australia, and hence deductible regardless of who makes the investment.

NFF believes that the Review should fully investigate the relative advantages of both the CIT and ET as a business tax base. In particular, the Review should address the following questions:

    • Which tax base is most likely to optimise growth in the Australian economy?
    • Are Australia’s trading partners more likely to move towards a CIT or an ET over the next decade?
    • What would be costs and benefits of Australia moving closer to a CIT or an ET?
    • Who are the ‘winners’ and ‘losers’ of each proposal?
    • What transition or compensation measures would be appropriate for each proposal? and
    • What would the tax expenditures under each proposal?

There are likely to be heavy economic costs in moving the tax base closer to either the theoretical CIT or ET bases. There are also substantial transition issues. For example, a move to either base could have substantial implications for the Government’s Retirement Incomes policies irrespective of the direction recommended. The Review will to show clearly that the benefits arising from any changes will substantially exceed the costs.

Schedular Tax Systems

Schedular tax systems lack the theoretical foundation of either a CIT or an ET. Rather they arise because of a perception that certain types of income should be treated in a different manner to other types of income. For example, Australia has previously imposed higher rates of income tax on unearned income than on earned income. Tax rebates for pensioners also create schedular systems in favour of a certain income source.

In recent years, many Scandinavian countries have adopted a schedular system where income from capital is taxed at lower rates to, and quarantined from, income from other labor. This choice was largely driven by the discovery that these countries were actually losing money from taxing capital – more deductions were claimed than income was returned. It is not clear if this is the case in Australia, but it must be a possibility given the popularity of negative gearing real property and shares. The Review should conduct research to determine if the net taxation collection from capital is positive or negative.

A compelling economic reason for adoption of a schedular tax system would be if different sources of income had different deadweight losses. In this case, it would be sensible to tax the income source with the lowest deadweight loss more heavily than the income source with the highest deadweight loss. With perfect knowledge, it would be possible to design a tax system that minimised the deadweight loss to society.

Little is known of the relative deadweight losses of different income sources in Australia. It is probable that the deadweight loss of taxing income from capital may be higher than taxing other sources of income. Research by Dale W Jorgenson in the US suggests that the deadweight loss of taxing capital in the US may be approximately twice that of taxing labor. He estimated the marginal deadweight loss of taxing labor at 48.2 per cent and capital at 92.4 per cent. In other words, raising an additional $100 of tax from labor shrinks the economic cake by $148, while raising an additional $100 of tax from capital shrinks the economic cake by $192.

The deadweight losses in taxing capital will undoubtedly be different (and probably less) in the Australia to the US. The Review should undertake research to estimate the relative deadweight losses of taxing labor and capital. If similar relativities are observed in Australia, there would be a compelling case to move closer to an ET, or to introduce reduced tax rates for capital if the Review chooses to move closer to a CIT.

3. Taxation and Risk

One disappointing aspect of A Strong Foundation was its treatment of risk. While it was correctly observed that the neutral treatment of risk required perfect loss offsets, or immediate tax refunds when a loss was incurred, the issue was dismissed by referring the need to protect the revenue and the observation that risk ‘is a property of asset portfolios and not merely of individual assets and liabilities’. There was no attempt to quantify the cost that this treatment of losses is imposing on the Australian economy.

Society is likely to have a different risk profile from the entrepreneur because it is better placed to withstand large losses. For example, consider a project where the expected value is $50 million, a positive addition to national wealth and beneficial to society. The equi-probable payoffs are $200 million or a loss of $100 million. Few entrepreneurs would consider such a project because the size of the potential loss would be catastrophic. If society is more risk preferring than the entrepreneur, then a case can be made for the tax system to encourage risk taking, not discriminate against it.

It is instructive to consider the theoretical treatment of losses under a CIT. Henry Simons’ fifth principle of a CIT included:

Full deduction should be allowed for all realised capital losses; but no deduction should be allowed to donors with respect to estimated losses on property transaction by gift; and only limited deductions, if any at all, should be permitted to estates with respect to assets not actually sold.

However, the Australian tax system does not allow perfect loss offsets, and therefore discriminates against risky investments. The tax system is the major mechanism where society shares the benefits and risks of investment with the investor. A tax system that does not allow full loss offsets of both revenue and capital losses will reduce risk-taking by business, and reduce economic growth.

Even with perfect loss offsets, the tax system is likely to discriminate against risky activities. This is because in a progressive taxation system, returns to successful investment are likely to be more highly taxed than losses from unsuccessful investments are subsidised. This is supported by recent research from the US National Bureau of Economic Research that argues that the taxation of income from risky assets in a small open economy is likely to reduce risk taking, and economic growth. The authors argue ‘The share of private investment is the single most important determinant of differences in cross-country growth performance’. While this research relates to South Africa, it is also relevant to Australia.

NFF is unaware of similar Australian research and recommends that the Review undertake research in Australia to quantify the effect the tax system has on risk taking, and the consequent cost to the Australian economy. Should the costs be of sufficient magnitude, NFF suggests that the Review consider recommending the introduction of more generous loss offsets for Australia.

In particular, NFF would urge the Review to consider the introduction of carry-back tax losses. Many OECD countries, and most of Australia’s trading competitors, allow taxpayers to offset current year’s losses against the tax paid in the previous three years. Compared to carry-forward tax losses, the carry-back of losses provides the firm with cash-flow when it is losing money, rather than lower taxes when the firm returns to profitability.

 

 

 

4. Assessment Periods and Measures to Alleviate Period Inequity

An important question that the Review has to consider is what is the appropriate assessment period for business taxation. The standard assessment period of a year is an arbitrary period, and there is no reason why the period could not be shorter, or longer. A compelling case can be made for a lifetime to be the assessment period for individuals.

In an ideal world, business investments would be taxed at the end of the investment, after the final profitability of the investment had been determined. Of course, there are practical reasons why this ideal cannot be met, such as the annual revenue needs of Government.

A result of assessing tax on a shorter period than the life of an investment is that a new inequity is introduced into the tax system. This inequity (‘period inequity’) arises when a progressive tax system results in more tax being paid on a variable income than would be paid on a similar total income derived in a more stable fashion over the same time period. The following example will illustrate the nature of period inequity.

Example. Assume that a project requires an investment of $100,000 in Year 1, and returns $250,000 in Year 2. The total profit is $150,000 and the average profit is $75,000 a year. If the project were the only source of income for a taxpayer (and assuming carry forward of losses is permitted), the tax payable in Year 2 at current rates on $150,000 would be $61,102. However, if tax had been assessed on two amounts of $75,000, the total tax liability would have been $51,704, some $9,398 less – the maximum period inequity possible over 2 years under current rate scales. (If the tax scales proposed in A New Tax System are implemented, the maximum potential period inequity will increase to $13,870 over a 2-year period.)

There are three important aspects to period inequity. First, period inequity becomes larger with shorter assessment periods, and reduces with longer assessment periods.

Second, individuals can, and do, choose to reduce period inequity by selecting mixtures of investments that will result in more stable investment returns. It would be open to an individual with the investment choice described in the above example to commence a project every year, so that in Year 2 and subsequent years a net profit of $150,000 would be received, providing a stable return. Of course, this action pre-supposes that the individual has the necessary capital to fund a second project, and that the projects are always available. In reality, investment opportunities are not available continuously, there is capital rationing, and the return periods from investments are unlikely to be so convenient. For example, investments in horticultural plantations may require a pre-productive period of many years, and then returns are spread over decades. Other examples of similar investment patterns include much research and development activity, such as biotechnology.

Third, many investments have inherently risky cash flows. The agricultural sector provides a good example of industries with risky cash flows. Production volumes are subject to climatic variability; a bumper season may follow a drought, or vice versa. Unexpected frosts can severely reduce harvests of grains and fruits. Once harvested, the sale price of produce is subject to the vagaries of corrupt world commodity markets. Farmers who hedge commodity prices can normally only do so for up to two years.

It is therefore imperative that the tax system does not discriminate against investments with variable cash flows. Henry Simons saw relief of period inequity as being an essential design feature of a CIT. Similarly, the US Blueprints for Tax reform saw a tax averaging system as being an integral part of a CIT. There is also a strong case for relief of period inequity if an ET is chosen as the tax base. Meade argued:

Equity in progressive taxation as between taxpayers with steady and taxpayers with a fluctuating tax base requires some arrangements for averaging lumpy tax liabilities over a period of years in both the cases of an income tax and of a consumption tax.

Whatever tax base the Review chooses as the appropriate benchmark, NFF believes that it is essential to include measures to alleviate period inequity within that benchmark.

 

5. Entities Taxation

A New Tax System proposed a common taxation system for trusts and companies involving the taxation of trusts as companies. Full details of the proposals have not been released to the public, but these measures are included in the TOR of the Review.

NFF believes that there is no theoretical justification for the separate taxation of entities. If a CIT is adopted as the benchmark tax base, US Treasury argued:

A separate tax on corporations is not consistent with an ideal comprehensive income tax base. Corporations do not ‘consume’ or have a standard of living in the sense that individuals do; all corporate income ultimately can be accounted for either as consumption by individuals or as an increase in the value of claims of individuals who own corporate shares. Thus, corporations do not pay taxes in the sense of bearing the burden of taxation. People pay taxes, and corporate tax payments are drawn from resources belonging to people that would otherwise be available to them for present or future consumption.

Similarly, if an ET is elected as the appropriate benchmark, taxation will occur when resources are withdrawn from the trust or company for consumption purposes. There is no need for taxation at the entity level.

The justification of the use of entities taxation to remove existing distortions that have crept into the current business tax system must be tempered with adequate consideration of existing social and commercial realities.

NFF opposes the introduction of entities taxation of family trusts. Family businesses should not be taxed as separate entities. Like other small family businesses, family farms are merely groups of closely related individuals who can be identified and directly taxed. When distributions are made the beneficiary typically can be identified and it is more appropriate that this beneficiary is taxed as an individual at the relevant rate. On the rare occasions where income is not distributed, it is typically invested in the future income generating potential of the farm. In line with the above philosophy, it is the people who should be taxed, not the entity.

Entities taxation will introduce its own set of distortions. It could act as a disincentive to rational economic decision-making - for example by discouraging collective action to maximise returns to investment or to minimise risk when individuals decide how and where to invest their superannuation and other savings. It will do this because those individuals who can afford to invest directly in property or the share market will be preferentially taxed compared to those who invest in a property unit trust or managed fund.

In much the same way taxing the entity could unfairly burden individual members of a farming family who have chosen to hold their principle asset in a trust (for reasons that have nothing to do with tax) compared to those who are able to hold it in a partnership.

There are a number of legitimate reasons for choosing to use a trust - not least of which being the ability to secure the principle productive asset can be maintained as a cohesive whole without identifying the principal beneficiary among the next generation and without disinheriting those who may not wish to directly participate in the farming operation.

In broad terms, the Australian tax treatment of trusts is similar to that of US S-corporations, which is described by CCH as:

In general, an S corporation does not pay any income tax. Instead, the corporation’s income and expenses are divided among and passed through to its shareholders, who then must report the income and expense on their own income tax returns.

The existing tax treatment of companies has a number of undesirable and unjustifiable features. The first of these is the claw-back of so-called tax-preferences. A good example of the inconsistencies in the existing law is provided by the tax treatment of long-term capital gains. As a design principle of the CGT system, Parliament has provided that only real (after inflation) gains are to be included in taxable income. This treatment is available to all entities, but when a company distributes the inflation gain to its owners, it is treated as an unfranked dividend and they are required to pay tax at their marginal rate on the supposedly tax-free component.

Similarly, it is a design feature of the CGT that assets acquired on or before 19 September 1985 are not subject to CGT. While a company may receive the proceeds form the sale of a pre-CGT asset tax-free, in most cases the proceeds will be treated as an unfranked and taxable dividend when paid to the shareholders.

The preferred treatment should be that currently allowed to discretionary trusts where the beneficiaries can receive any tax preferred amounts tax-free. The underlying principle should be that once a transaction receives a certain tax treatment, that treatment should continue through to the ultimate owner of the business regardless of whether it is a sole trader, a partnership, a trust or a company. This is particularly so if the Government wishes to continue to make effective use of the tax system to facilitate investment in sustainable agriculture and appropriate environmental activities.

Should the Review decide to recommend a significant change to the taxation of trusts, it is possible that trusts will no longer be a suitable business structure for many businesses. In particular, if the existing tax treatment of companies is imposed on trusts holding assets (such as land), the benefits of CGT indexation (and exemption) will be effectively removed from the trust. If this were to occur, NFF believes that it is equitable that such trusts be granted a ‘window of opportunity’ allowing for the assets to be transferred to the underlying owners retaining their existing CGT status and free of all State stamp duties. NFF believes that a strong case can be made for the Government to also compensate the owners of such businesses for all legal and accounting costs incurred in such transactions.

Should Government choose not to make a ‘window of opportunity’ available, A New Tax System proposes that all assets of trust will have to be valued as at 1 July 2000. This will impose significant compliance costs on small business, in particular farmers. NFF believes that the cost of valuing a typical farm would be in the range of $3,000 – $5,000 (or up to $500 million for the farming sector). If the Government chooses to put taxpayers to this unnecessary expense, NFF believes that they should be fully compensated.

A further impact of applying entities taxation to trusts will be that many family businesses will become permanent creditors of the ATO. This will arise because PAYG tax will be deducted from the trust at the corporate tax rate, although most beneficiaries will not have an average (or marginal) rate of tax as high as the corporate rate. If the rate schedules in A New Tax System are adopted, the marginal tax rate of a taxpayer will not exceed 30 per cent (the proposed corporate rate) until taxable income exceeds $50,000.

For many family trusts, entities taxation will result in more tax being collected at entity level than will ultimately be paid by the beneficiaries. Assuming beneficiaries will only be able to claim imputation credits on final assessment, the net effect for a family trust with an annual income of $80,000 and four equal beneficiaries is that $13,280 more tax would be payable by the trust than would ultimately be paid by the beneficiaries. $24,000 will be collected at trust level, more than double the family’s ultimate liability of $10,720. (Full refunds of imputation credits mean that the family will eventually receive a refund of $13,280.) Put another way, 16.6 per cent (or 1 dollar in 6) of the trusts profits will be used for a compulsory and interest free loan to the Government. The introduction of the PAYG system would also ensure similar results for many family companies.

Should the Government continue with the collection of taxation at the entity level, NFF urges the Review to devise a mechanism that ensures that the tax collected at the entity level is a close approximation of the final liability of the beneficiaries and shareholders.

6. Transition Measures

It is well known that in a market economy, after-tax returns from different classes of assets tend to equality over time. As a change in the tax treatment of an asset affects after-tax returns, it will also affect the capital value of an asset. If the new tax treatment is more generous than the norm, the price of the affected asset is likely to increase; and vice versa.

Large-scale tax changes such as proposed in A New Tax System are likely to change the relative prices of many assets. In particular, reductions in capital write-off rates are likely to reduce the value of affected assets. Those taxpayers holding affected assets will be adversely affected in two ways. First, their after-tax cash flow will be reduced into the future. Secondly and more importantly, the value of their assets will decline, effectively making such changes a wealth tax.

If such changes merely reversed recent changes to the tax system, it could be argued that a certain ‘rough justice’ had prevailed: the windfall loss merely offset an earlier windfall gain.

However, if changes are made to long-standing provisions of the tax system (such as the accelerated depreciation provisions), it is more likely that the holders of such assets will have paid an increased price for those assets and did not receive a windfall benefit from earlier changes in tax policy. If this were to be the case, affected taxpayers would have a strong case for compensation unless an adequate transition path is provided.

As discussed earlier, if substantial changes are made to the tax treatment of business entities, there will be a clear need for a ‘window of opportunity’ for businesses to divest themselves of existing business structures free of CGT and State stamp duties.