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Review of Business Taxation
Submission in Response to
A Discussion Paper issued by the Review of Business Taxation
24 December 1998
In response to "A Strong Foundation" and the Government proposals in ANTS, Shaddick & Spence makes the following observations:
In the attached submission, we have not sought to comment on the detailed proposals made by the Federal Government in ANTS. This commentary will be made following the release of the second Discussion Paper of the Review of Business Taxation.
24 December 1998
This paper constitutes the submission of Shaddick & Spence in response to the Discussion Paper of the Review of Business Taxation ("the Review") titled "A Strong Foundation" issued in November 1998.
At page vii of its Discussion Paper, the Review indicates that it invites members of the community to make submissions relating to the matters raised in "A Strong Foundation". This submission is made in response to that invitation. The submission is made on the basis that it will be treated as public and the Review is open to quote or publish any part or the whole of the submission.
In the preparation of this submission, we have not sought to comment on all of the issues raised and discussed in "A Strong Foundation". Rather, we have sought to comment only on matters which we believe warrant comment and for which we believe we have an appropriate level of expertise and experience.
In addition, we have not sought to comment on the proposals made by the Federal Government in August 1998 in its paper, A New Tax System ("ANTS"). The Review has indicated that it will issue a further discussion paper in late January or early February 1999 which will detail its recommendations in regard to the specific design issues raised by the taxation strategies announced by the Government. We propose to make detailed submissions on these issues, including international taxation issues and the treatment of entity distributions, in response to that later discussion paper.
As a final introductory remark, we wish to express our support for the process initiated by the Federal Government in ANTS and the work being undertaken by the Review. Whilst we do not support all of the proposals made in "A Strong Foundation", we strongly support the Discussion Paper in its purpose and the process it has established. We wish the comments below to be understood in the context of this general support for the current debate.
2. Legal Reality & Fiscal Fictions
A significant issue raised by the proposals of the Federal Government in ANTS is the relationship between the legal reality of a transaction or business entity and its proposed treatment for taxation purposes.
In the future, tax treatment will arise from a fiction.
In ANTS, the major proposals for reform to the business tax system are almost uniformly founded upon a departure from the legal reality of either a transaction or the conduct of a business entity. There are many examples:
It may be that in certain instances these taxation treatments are a move towards the economic substance of the transaction. Equally, some proposals, especially the proposed taxation of trusts as companies, could be said to be a move away from economic substance. Nevertheless, each proposal involves the adoption of a "fiscal fiction" as the first step in the operation of the business tax system and ignores the legal reality of the business entity or the particular transaction.
In neither ANTS nor in "A Strong Foundation" is consideration given to this divergence and its consequences for legislation, tax administration, and commercial behaviour.
What observations can be made on this dichotomy?
In our opinion, the following observations can be made about the adoption of a fiction as the basis of the business tax system.
These observations are not presented as an argument against the proposals made by the Federal Government in ANTS. Rather, the purpose of these observations is to highlight some important considerations that should be made in the development of these proposals and in the development of tax policy and legislation generally. It is intended that these observations will highlight the actual legal effect of transactions as an important principle within the operation of a business tax system. That principle should not be abandoned lightly.
The divergence of legal reality and fiscal treatment is not necessary.
In "A Strong Foundation", one of the suggested policy design principles for the business tax system is a single layer of domestic taxation. To achieve vertical equity, it is then recognised that this single layer of taxation must effectively be applied at personal income tax rates. Accordingly, the Review recognises that vertical equity will be achieved if the business taxation system ensures that business income is ultimately taxed in the hands of individual beneficiaries. Taxation on this basis will achieve a single layer of domestic taxation and will also achieve horizontal equity which is also a proposed policy design principle of the business taxation system.
In the development of the business tax system, there would appear to be two ways to respond to these policy design principles:-
The current system, which is much criticised, is an imperfect application of the first alternative. The proposal made in ANTS, being the imposition of company taxation to all business entities which provide limited liability, is an example of the second alternative.
In the present business tax system, the particular legal nature of each type of business entity is recognised and the taxation system seeks to operate in conformity with that nature. Hence, a company, being a separate legal personality, is subject to taxation. In contrast, the trustee of a trust is only taxed where the income of the trust does not flow to its beneficiaries. Limited partnerships and public unit trusts are acknowledged exceptions to this rule given that they are taxed as companies, which is considered to be their economic substance, notwithstanding their different legal nature.
It should be appreciated that the first alternative is not inherently flawed. The problem with the current taxation system is not its conceptual approach but rather the specific rules through which it is applied. These rules do not tax the income and capital flows to individual beneficiaries equally, irrespective of the nature of the business entity involved. This inconsistency arises from weaknesses in the taxation rules which apply to the income and capital flows by each type of entity and a failure to develop appropriate policy and legislative positions for the consequences of legal and beneficial ownership of each entity.
In our opinion, little effort has been made to achieve equalisation between different business entities under the current system. Indeed, distinct outcomes for individual beneficiaries, based upon the nature of the business entity involved, has been a
The New Business Tax System can have the same weaknesses.
The difficulty encountered by the adoption of a legal fiction as the basis for the operation of the tax system is that it inherently means "transformation rules" are necessary. These special rules would be needed to impose the uniform tax system, say the company taxation system, onto entities which are not themselves companies.
Such transformation rules operate to transform transactions so that they have the nature which makes them equivalent to the transactions which may be undertaken by a company. This transformation allows the taxation treatment for such company transactions to apply. For example, a distribution of capital by a company may be deemed to be a dividend; the vesting of a trust may be deemed to be the liquidation or wind-up of a company; and the re-purchase of units by an unlisted trust may be deemed to be an off market share buy-back.
These rules will themselves add complexity to the taxation system. However, beyond this complexity is the concern that these rules should operate effectively, universally and uniformly. If they fail to do so, arbitrage opportunities will arise in the taxation system in the same manner that such opportunities presently exist. Such an outcome would mean the replication of the weaknesses of the present system.
A failure to follow legal reality is counter-intuitive.
What this discussion demonstrates is that the adoption of a uniform taxation system for all business entities is counter-intuitive.
With limited exceptions, the present tax system does not suffer this weakness because the taxation consequence of a transaction is typically consistent with the inherent nature of the transaction. Thus, the derivation of income by a trust and the distribution of that income to beneficiaries recognises that the beneficiaries are ultimately entitled to the income and so should be taxed on their entitlement. The beneficial ownership of the income by the beneficiary attracts taxation.
In contrast, under the proposed entity taxation, the trust will be considered to be, for taxation purposes, the beneficial owner of the income and be required to satisfy its taxation liabilities from that income. This, of course, is contrary to the actual reality, especially for a bare trust.
The difficulty with such a counter-intuitive taxation system is that it is inherently more difficult for non-specialists in the taxation system, especially business and commercial people, to understand. Such a taxation system operates in a manner contrary to their understanding of how the business entity commercially operates. This problem will not be alleviated by simple legislative expression, policy statements within legislation, and user focus. Indeed, in our opinion, the legislative design principles should place some value on a tax system which is commercially and legally intuitive.
The proposals made in ANTS will alter commercial behaviour.
It must therefore follow that, if the taxation system ceases to treat an entity or transaction according to its particular nature, and so operates counter-intuitively, it will also operate to alter the behaviour of that entity.
Among the reasons why trusts presently distribute income to beneficiaries is that no taxation incentive for retention exists. In contrast, under the proposals made in ANTS for an entity taxation system, a trust will be taxed as a company and will have an incentive to retain income, especially tax preferred income, due to the operation of the deferred company tax. It is likely that this income will be reinvested or ventured into a new business pursuit by the trust rather than distributed to the individual beneficiary.
Equally, companies can presently return capital to shareholders without undue penalty under the taxation system. If a "profits first" rule for corporate distributions is adopted, such a distribution may attract a taxation treatment which does not accord with the reality of the transaction. This will create a disincentive to make capital returns and may encourage companies to retain capital when their effective use of that capital has ceased. Such a principle would appear to be contrary to the economic growth policy proposed in "A Strong Foundation".
Another bias that may be created in business affairs is between the balance of debt and equity invested in business entities. The combination of the proposed deferred company tax with entity distribution rules will collectively encourage business entities to obtain debt finance from their individual beneficiaries rather than equity finance. This may have consequences for the economic viability of some business entities or may alter the availability or cost of working capital.
What the design principles of any business tax policy should determine is whether deviations in commercial behaviour are an appropriate or desirable consequence.
3. A Simplified Tax Calculation for Small Business
In "A Strong Foundation", consideration is given to the design of the tax law from the perspective of the users of the law. It is recognised that small business entities are not able to deal with complex tax legislation whereas larger entities such as multinational corporations can more readily manage necessarily complex legislation.
In support of this principle, it is recommended that a distinction should be made in the tax system between simple business entities and other business entities, by introducing a highly simplified taxation system for small business entities. This system would attempt to minimise both tax decisions and tax planning for a small business. The treatment of the small business would be determined by fewer rules and the rules that did apply would have straightforward application.
This distinction could be made by introducing a simplified tax calculation and a simplified income tax return for small business entities. The filing and lodgement of this calculation/income tax return could be co-ordinated with the requirements necessary under the Goods and Services Tax. We envisage that resident business entities with a turnover under $500,000 would qualify for the simplified tax calculation.
The simplified tax calculation could have a number of elements. For example, it would operate on a legislatively prescribed cash basis so that the taxpayer would only be assessed on income received and receive a deduction for amounts actually paid. All capital expenditure, irrespective of its nature (but excluding the cost of land) could be booked to a single capital expenditure account. Each year, the taxpayer would be allowed to claim a deduction equal to, say, 20% of this capital expenditure account. In this manner, the business entity would obtain deductions for depreciation, other types of fixed asset expenditures and black hole expenditures which otherwise generate no tax relief. If a capital asset was disposed of, the consideration would operate as a reduction in the capital expenditure account. If the capital expenditure account moved to a deficit on disposal of an asset, the deficit amount would be included in assessable income.
We propose such an approach as a solution to the difficulties of the business tax system for the small business community. It should be recognised that we do not consider our proposals fully developed. Rather, we recommend that the Review consider whether such a secondary system could be adopted and how it would work.
4. Design Principles
Chapter 6 of "A Strong Foundation" details legislative policy and administrative design principles for the business tax system.
We have already observed in this paper that an appropriate legislative policy design principle may be whether the business tax system is commercially and legally intuitive.
4.1 Unintended Consequences
One of the significant difficulties with recently enacted tax legislation is its lack of appropriate focus and the insufficient attention given to the need to ensure that transactions and circumstances which are not within the intended scope of the policy or legislation are excluded from its operation.
A recent example of this weakness is the provisions to deny certain capital losses contained in Taxation Laws Amendment Bill (No. 2) 1998.
These provisions are intended to prevent the duplication of capital losses within corporate groups. However, due to the poor design of the provisions and the failure to give proper consideration to the underlying policy, the provisions actually operate to deny capital losses which are not within their intended scope. That is, the provisions operate to deny capital losses to a member of a corporate group where no duplication of tax losses occurs.
When the provisions were introduced into the former Parliament as part of Taxation Laws Amendment Bill (No. 6) 1997, they provided no relief for this circumstance. To alleviate this problem, a discretion has been provided in the reintroduced provisions to allow the Commissioner to provide relief in certain circumstances. This is obviously an insufficient response to the operation of legislation which will operate outside of its policy bounds.
Unfortunately, there are very many other examples of this problem.
4.2 Role of Anti-Avoidance Provisions & Scope of Legislation
A further failing in tax legislation currently developed is the attempt to ensure that the legislation specifically captures all of the possible cases within the scope of the policy, however remote. We consider that general provisions would often be more effective.
Typically, the fundamental or basic aspects of any legislative development will capture the substantial majority of anticipated transactions. There may however be some transactions which are not within the overt operation of these basic provisions. The pattern of recent legislative change has been to introduce special anti-avoidance provisions to capture these transactions as well. This practice has unfortunately escalated the complexity of amending legislation. It means that amendments often include difficult and obscure associate tests, complex tracing provisions, and complex interposed entity provisions.
Recent examples of this type of legislation include the income injection test under the recently introduced Trust Loss provisions. Briefly, the income injection test is predicated on the basis of an exchange of benefits. That is, a third person (outsider) provides a benefit to a trust which has allowable deductions or tax losses so that it derives income to offset against its deductions/tax losses. In return, a benefit will be provided to the outsider by the trust. The associate provisions (which extend the operation of the test) are such that the benefit provided by the trust to the outsider can be deemed also to be the benefit provided by the outsider to the trust. Such an interpretation is obviously ridiculous and will necessitate difficult tax administration problems.
An example of the opposite (and preferable) approach is the repeal of Sections 159GZO and 159GZP from the thin capitalisation provisions of the Income Assessment Act 1936 ("the 1936 Act"). The provisions, which previously applied interposed entity tests to trace foreign debt for thin capitalisation purposes, were repealed by Taxation Laws Amendment Act (No. 4) 1997. The Explanatory Memorandum to this Act indicated that in future, reliance would instead be placed on the general anti-avoidance provisions.
It is recommended that a legislative design principle should be that tax legislation is focussed squarely on the main purpose of the relevant policy, and relies upon the operation of general anti-avoidance provisions and the intervention of the courts to ensure that the policy is not infringed upon. The legislation should be designed so that it is effective without specific anti-avoidance provisions.
4.3 Taxation Policy/Black Letter Law
In "A Strong Foundation" consideration is given to the statement of tax policy principles in tax legislation and the role of "black letter law" in taxation legislation.
In our opinion, tax legislation is best drafted as black letter law but, consistent with our comments at 4.2 above, it sometimes needs to be "fuzzy at the edges". All taxpayers including business entities seek certainty as a fundamental quality in tax legislation. Admittedly, certainty can be obtained by both black letter law and "fuzzy law" which is subject to recognised interpretation and common law positions. However to achieve certainty with fuzzy law depends excessively upon the role of the courts and a consistent body of interpretive guidelines.
An example in taxation of fuzzy law is arguably the treatment of income. Both the 1936 Act and the Income Tax Assessment Act 1997 ("the 1997 Act") assess "income" without attempting to provide any interpretation for the meaning of that term. Thus the broad principle of the legislation upon which taxation applies has no guidance as to its actual application. This guidance has been developed by the courts and, to some extent, by the Commissionerís income tax rulings. Unfortunately, this guidance has not always been consistent and recent decisions of the High Court and the Federal Court in cases such as Coles Myer Finance Ltd v FCT, Cooling v FCT, Orica Ltd v FCT and Montgomery v FCT demonstrate the difficulties encountered. We therefore recommend the use, wherever appropriate, of black letter law.
Equally, we do not support the proposal to include statements of intention or policy within the tax legislation. Taxpayers can obtain the benefit of statements of intention or policy, and these can be of assistance to the courts where appropriate, if these statements are included in appropriately drafted explanatory memoranda. One of the present problems with tax legislation is that explanatory memoranda often merely parrot the legislation drafted. The explanatory memoranda also sometimes fail to explain properly the policy of the legislation and the reason for its introduction. A recent example is the difficulty in finding, in the explanatory memorandum for the imputation provisions when originally introduced, the policy authorising the recent amendments which deal with dividend streaming and associated transactions.
The benefit of policy guidance could be provided in explanatory memoranda. It is also doubted that sufficient detail can be provided within the body of legislation to make any policy statements meaningful or explicit.
5. Leadership & Consultation in Business Tax Development
In recent years, Shaddick & Spence has consulted with Treasury and the Australian Taxation Office ("ATO") on business tax policy and the legislation proposed to apply the Governmentís policy formulation. This experience allows the following observations to be made regarding the current process of developing policy and legislation in the business tax system:
(iii) The Government is unable to consult effectively with external parties without the assistance of the Treasury or the ATO. This assistance means that the Government is insufficiently free of the bureaucracy to make its own assessment of the legislation or policy under consideration.
In "A Strong Foundation", it is observed that currently neither the Treasury, the ATO nor the Office of Parliamentary Counsel can ensure or be held accountable for ensuring, that the original intent of policies is translated into legislation and administered according to that intent. It would seem clear that the role of the Parliament and the Executive Government is to ensure that its policy is being properly enacted and correctly administered. Indeed, this is the role of Government in all facets of law, not merely taxation. Nevertheless, the mere existence of the Review demonstrates that neither Parliament nor the Executive is able to fulfil this role with regard to the business tax system.
Does "A Strong Foundation" resolve these problems?
Although the proposals made in Chapter 7 of "A Strong Foundation" will contribute to the resolution of some of the difficulties detailed above (and are supported by us for this reason), we do not believe it will eliminate these problems.
Tax policy and the operation of the business tax system remain fundamentally the responsibility of the Government and then the Parliament. To carry out this responsibility, the Government must be able to understand the operation of the system, and independently and analytically review policy proposals and legislation presented by the bureaucracy. It must also be able to receive and evaluate external consultation and respond to that consultation when appropriate. In essence, the Government must be able to provide leadership in the maintenance of the business tax system.
The faults with the business tax system identified at paragraphs 4.38 to 4.40 of "A Strong Foundation" arise from the present inability of the Executive and Parliamentary arms of Government to provide that leadership. In our opinion, this inability will not be resolved by the proposals made in Chapter 7. Indeed, we believe that the inability to resolve the difficulties is exhibited by the somewhat uncertain remarks made in paragraphs 7.67 to 7.72 of "A Strong Foundation".
To resolve this situation, we make the following recommendations:
These recommendations constitute an attempt to obtain the advantage of a "US-style" Executive Government appointment within the restrictions imposed by the Australian Constitution.
By following the recommendations set out above, in accord with the operation envisaged as described below, it is hoped that the Executive Government could obtain the benefit in taxation policy and legislation of highly qualified specialist leadership skills, yet within the present framework of our system of Federal Government.
Briefly, the outcome envisaged from the recommendations made above is as follows:
At paragraph 7.24 in "A Strong Foundation" the Review states that it believes:
"One aim of the reformed process should be to ensure the maximum possible extension to the scope for public consultation in the development of business tax policies. As a general principle, the bulk of business tax policy development should be subject to consultation."
This recommendation is made following the observation at paragraph 4.26 that at present the opportunities for contribution to the formulation of policy and legislation are limited. The proposed means to contribute to policy and legislation in the future are detailed in paragraph 7.25 to 7.28.
Shaddick & Spence agrees that consultation should exist within the business taxation system to:
However, we caution that consultation should not be considered to be a panacea for many of the weaknesses of prior developments in tax policy and legislation. We further believe that consultation should not be introduced without the imposition of appropriate discipline and controls on the nature and form of consultation. These controls should include defined timeframes for consultation, selective consultation specialist groups, and clear procedures for the consultation process.
The problem of consultation is best exemplified by the Taxation of Financial Arrangements proposals. These were initiated in December 1993 and have now been the subject of two rounds of substantial consultation. While it can be observed that this consultation has allowed the input of taxpayer views, the most fundamental observation is that an appropriate legislative system still does not exist.
6. Implications of the Review of Business Taxation
In conclusion, we believe it is appropriate to comment on the direct implications of change to the business tax system.
Significant change is likely.
In ANTS, the Federal Government has proposed significant changes to the business tax system including deferred company taxation, entity taxation, consolidated tax returns for entity groups, and a new entity distribution taxation regime. There are also proposals regarding the taxation of business investments and the payment of entity taxation liabilities. Although these proposals will be subject to consideration by the Review, it is likely that a substantially different business taxation system will operate from the income year commencing 1 July 2000. Indeed, the extent of the proposed change means it is probably fair to presume that there will effectively be a new business taxation system operable from that date.
What are the implications of a new business taxation system?
The most immediate implication from the introduction of a new business taxation system is that business entities will in fact be subject to the operation of two taxation systems from 1 July 2000.
Business activities and transactions undertaken from 1 July 2000 will be subject to the new business taxation system and business entities and individuals will need to evaluate the implications of this new system upon their business and its transactions. Given the need for business entities and individuals to plan their taxation affairs, consideration of the new system will undoubtedly commence prior to its introduction.
At the same time, business entities and individuals will still be subject to the former business tax system in regard to the income years up to and including the year ended 30 June 2000. A great deal of corporate tax administration involves the management of taxation issues relating to prior income years. These issues arise from the requirement to lodge income tax returns for those prior years or to amend income tax returns to account for facts or circumstances which are only properly determined after returns have been lodged. They also arise from audit activity of the ATO (which is almost uniformly historical) and from the implications of subsequent judicial decisions. Although assessments can only be amended within four years, taxpayers who are not assessed in a particular income year may be subject to audit activity which considers transactions up to ten years or more prior to the current income year. Equally, litigation is often concerned with transactions which are more than ten years old by the time they reach the court system.
The new business tax system will create difficulties.
This situation means that from 1 July 2000 two fundamental difficulties will arise for business entities which will detrimentally impact upon their ability to operate under the business tax system:
To achieve the benefits of the introduction of the new system as soon as feasible and to accelerate transition to the new system, it is recommended that sunset restrictions be placed on the operation of the existing business taxation system. These restrictions could include:
1. That no adjustment be allowed to the taxable income or carry-forward loss determined for any income year prior to and including 1 July 2000 after 1 July 2004, except in cases of fraud or wilful evasion. That is, the Commissioner of Taxation would be denied the ability to issue an amended assessment or to adjust the carry-forward losses of any entity after 1 July 2004 for any income year up to the year ended 30 June 2000. Equally, taxpayers would be denied the ability to make any application to adjust their taxable income or the amount of carry-forward loss arising in any income year including and prior to the year ending 1 July 2000 after 1 July 2004. The proposal for a four year period accords with the current rules regarding the ability to issue amended assessments under the 1936 Act.
2. In addition, a sunset restriction would be placed on commencing any litigation or the resolution of any amended assessment or loss adjustment arising from an income year ended 1 July 2000 or any prior year. It is suggested that an appropriate sunset period would be 1 July 2006.
Immediate aggregation of Assessment Acts
A further difficulty in the current administration of taxation for business taxpayers is the existence of two Income Tax Assessment Acts. This circumstance is an unnecessary administrative burden.
It is noted from ANTS that the Government proposes that tax laws will be brought together in a code which supports a more cohesive approach to compliance and administration. It further proposes that the tax code and the tax system will integrate all the tax rules using consistent terminology and definitions.
The progress of the Tax Law Improvement Project demonstrates that any attempt to re-write the current tax legislation or to establish such a code will take a substantial period of time. Accordingly, to simplify tax administration, it is recommended that there is only one operative Income Tax Assessment Act from 1 July 2000. It is further recommended that this aggregation be achieved by merely incorporating the relevant portions of the 1936 Act, in their current form, into the 1997 Act. Once incorporated, unnecessary provisions can be deleted and the remaining provisions can be amended and improved in accord with the style adopted by the Tax Law Improvement Project.
We recognise that this process of incorporation would require the provisions of the 1936 Act to be re-numbered into the 1997 Act and would also require some standardisation so that defined terms in the 1997 Act could be applied to the 1936 Act.
[End of Submission]