|Submission No. 30||Back to full list of submissions|
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TAX LINEARITY AND RISK NEUTRALITY: A VITAL FOUNDATION FOR AN EFFICIENT AUSTRALIAN BUSINESS TAX SYSTEM.
© Tony Rumble *
The Australian Government’s Review of Business Taxation has released its first discussion paper, inviting submissions about the "objectives, principles and processes" relevant to contemporary business taxation. Entitled "A Strong Foundation" ("ASF"), that paper poses questions about the framework of business taxation. The paper has been released in the context of an Australian economy which is now exposed to significant business risks, characterised by net capital imports, and where Australian business is competing for profits and capital on a global stage.
This submission proposes that neutral taxation of risk must be the key objective of rational business tax policy. This means that to ensure future Australian economic prosperity and job creation in the face of global competition, the Australian tax system should be efficient and facilitative both of orthodox and innovative financial transactions. Part I of this submission lays out some tax policy criteria for the neutral and efficient taxation of risk and the financial markets, by analysing the importance of the market arbitrage function to socio-economic wealth. The importance of a facilitative tax approach to arbitrage and risk transfer securities such as synthetic equity instruments is highlighted, and linked to the possibility of lower costs of corporate capital and enhanced investment returns for users of the innovative instruments. Part II of this submission responds to specific issues raised in the ASF paper, in the context of the facilitative tax policy approach suggested in Part I.
This submission recommends the adoption of an economic substance approach to taxation of the financial markets. To support this economic substance approach, a financial methodology which can verify the efficiency and non-tax drivers of financial innovation is outlined (the "Tax ReValue" method). To complete this facilitative and efficient approach to financial market taxation, the submission endorses the ASF suggestion concerning the need to remove a wide variety of specific anti-avoidance rules in the current tax system. Since these rules are a response to systemic failure in the tax laws, a more coherent tax system needs to be designed as a necessary precondition for the removal of some (but not all) of the nominated anti-avoidance rules. This task requires the removal of the tax law debt/equity distinction. The submission states that the general improvement in the coherence of the tax system can be measured by the degree to which tax linearity is observed.
TABLE OF CONTENTS.
SUMMARY OF RECOMMENDATIONS.
I. A STRONG FOUNDATION: THE ECONOMIC AND
FINANCIAL CONTEXT OF BUSINESS TAX REFORM.
B. THE TAXATION OF RISK.
C. THE BENEFITS OF TAX EFFICIENCY.
D. THE NEW PARADIGM: SYNTHETIC FINANCIAL
E. THE ROLE OF ECONOMIC SUBSTANCE IN BUSINESS
TAXATION: THE "TAX REVALUE" APPROACH.
II. SPECIFIC OBSERVATIONS OF THE REVIEW OF
BUSINESS TAXATION: "A STRONG FOUNDATION" FOR
THE TAXATION OF RISK.
A. NATIONAL OBJECTIVES FOR BUSINESS TAX REFORM.
B. ENTITY TAXATION, DIFFERENTIAL TAXATION AND TAX INCOHERENCE.
C. THE COMPREHENSIVE INCOME TAX BASE.
D. TAX POLICY AND ADMINISTRATION.
SUMMARY OF RECOMMENDATIONS.
As part of the overall design of a new tax base, the treatment of depreciable assets now in place, the taxation of financial arrangements, transitional provisions and international taxation implications would all need consideration. With these considerations and its reporting timeframe in mind, the Review has interpreted its terms of reference as confining its attention to an income tax base as the relevant operating principle.
I. A STRONG FOUNDATION: THE ECONOMIC AND FINANCIAL CONTEXT OF BUSINESS TAX REFORM.
The first discussion paper released by the Australian Review of Business Taxation, "A Strong Foundation" ("ASF") focusses on the taxation of two elements of business activity: the treatment of business entities and investments. The issue common to these two aspects of business taxation is the treatment of risk, since it is the deployment and transfer of risk which is the defining element of business activity in the liberal marketplace.
This submission suggests that a core objective of the RBT should be to maximise the neutrality of the tax response to the transfer and management of risk, thus promoting business tax efficiency whilst maintaining taxpayer and social equity.
This outcome is desirable since it facilitates (but does not subsidise) financial markets transactions and financial innovation, a necessary ingredient of a sound and globally competitive economy. This objective can be achieved by the removal of specific risk distorting tax avoidance rules which are now redundant (eg, s.82SA Tax Act, which applies to convertible notes). The promotion of risk neutrality also requires the removal of the debt/equity distinction, so that a wide range of other anti-avoidance rules can also be removed, (eg the "debt dividend," "dividend stripping" and "franking credit trading" rules.)
Tax efficiency is directly linked to economic prosperity and job creation. A core ingredient of an efficient and equitable business tax system is "tax linearity," a condition where consistency and universality of tax outcomes is available. Reflecting this consistency and universality, tax arbitrage possibilities are significantly reduced (or altogether removed) in a linear tax system, since transactions with different legal form are taxed consistently where they have the same economic profile. Accordingly, a linear tax system will contain minimal tax avoidance rules, thus promoting the facilitation of orthodox as well as novel or structured financial transactions. Some core ingredients for a linear business tax system are outlined in this submission.
Part I of the submission develops a normative framework for the taxation of risk. In this context, the submission proposes a financially realistic tax analytical tool, to assist the economic substance analysis, which is a necessary part of a linear tax system. The financial analytical tool is known as "Tax Effected Regulatory Efficiency Valuation" ("Tax ReValue"). Tax ReValue allows for the evaluation, and inclusion in tax analysis, of the non-tax efficiency drivers of financial transactions, and facilitates efficient transactions. Tax ReValue provides a mechanism for analysing why a transaction has been entered into, and guides the administration of an efficient and linear business tax system, based on the alignment of tax outcome for economically equivalent transactions. Tax ReValue is an important response to the acknowledgment in the ASF paper that, concerning the interpretation of the current anti-avoidance rules in our tax laws:
…no underlying principles are discernible from the current legislation.
The Tax ReValue methodology is seen as a significant improvement from the current incoherent approach, which attempts partial linearity through a primitive economic substance approach. The current approach is based on the denial of certain tax benefits simply because the financial attributes of one type of tax "preferred" transaction approach those of another, less tax preferred transaction. The current approach often attacks risk managed or risk transfer transactions, because of this simplistic economic substance foundation.
Part II of this submission responds to key discussion points in ASF, including the scope and role of entity taxation and "Deferred Company Tax," the tax treatment of financial arrangements; the impossibility of continuing the debt/equity distinction in tax law; the necessary removal of anti-avoidance rules; and the future of tax policy formation and tax administration.
Before we move to a closer examination of the current business tax reform debate, this submission analyses the aggressive taxation of risk imposed by the Australian tax system. This involves an appraisal of current and future trends in savings and investment in the Australian market. These trends are exemplified by investor attitudes to the sharemarket, since this asset class provides the highest long term investment returns, but with the most risk. Getting the investment profile "right" is the goal of risk management involving the structured or synthetic equity products which are beginning to proliferate, in Australia and globally.
These innovative products involve the transfer of risk between investors and security issuers. In Australia (unlike the US market) the new products are typically met with a negative tax response, involving the denial of tax benefits which are available to more orthodox securities or structures. The negative tax response is observed in the denial of the equity tax benefits to many synthetic equities, and the denial or restriction of the debt tax benefits to geared or quasi-equity products. Apart from the positive tax revenue implications which flow from this tax benefit denial, this approach reflects a systemic failure of the current tax system to embrace risk management and financial innovation. That is, the current tax policy stance attempts to restore tax "consistency" by attacking a range of innovative products through a denial of tax benefits, ignorant of the financial benefits which the risk transfer process contained in the new products delivers.
Attempted imposition of absolute universality in a differentiated tax system, such as that which characterises our current tax regime for investment capital, is simply exacerbating the incoherence of the current tax system. Aggressive attempts to deny the availability of franking credits is, like arbitrary attempts to minimise tax deductibility for losses, (such as by quarantining negative gearing or otherwise attacking interest deductions), currently producing a significant distortion in the capital markets. Many of our leading corporates are being forced to raise capital in the US markets, because of the tax law foreclosure of financial innovation in the Australian markets. Corrective anti-avoidance measures such as TOFA and the Budget are only a second best approximation of the real possibility which deep and systemic reform can provide. The scope of the systemic reform which the RBT is now seeking must facilitate the efficient operation of the risk transfer market, and its modern focal point, the innovative financial product.
B. THE TAXATION OF RISK.
Risk is the essential contextual issue for business tax policy.
The RBT is to be congratulated on its desire to map rationally the context within which business tax reform is being considered. Reflecting that contextual approach, this submission focusses on the taxation of the core attribute of business transactions in a liberal market economy: the transfer between market participants of risk. The proposition inherent in this statement asserts that the risk transfer process is the defining or essential context within which a modern business tax policy operates. The most efficient vehicle for the carriage of the risk transfer process is the market for financial innovation.
The 1997 Nobel Prize for Economics was awarded to Robert Merton of the Harvard Business School. The award was attributed to his work on option pricing, risk management and financial innovation. In his seminal article on the utility of financial innovation, Merton made the striking observation that:
There are some in the academic, financial, and regulatory communities who see all this innovation as nothing more than a giant fad, driven by institutional investors and corporate issuers with wholly unrealistic expectations of greater expected returns with less risk, and fuelled by financial services firms and organized exchanges that see huge profits from this vast activity. From this viewpoint, opportunists develop innovations that have no function other than to differentiate their products superficially…One widely accepted theory is that cost reduction or otherwise lessening the constraints of regulation including taxes…is a driving force behind financial innovations.
The populist rhetoric essayed by Merton reflects the new luddite attack on the financial markets, a key cause of the Australian failure to systematically embrace financial and corporate innovation. Needless to say, Merton went on to debunk the validity of this style of analysis. The tools he deployed rely on the consideration of the financial attributes of the new products. He focussed on the propensity of financial innovation to enhance risk management, and concluded that, despite their detractors:
(Financial) innovations have greatly improved the opportunities for households to construct portfolios with more efficient risk-return tradeoffs and payoffs tailored more closely to changing needs throughout an investors life-cycle.
(It) is possible to have an innovation motivated entirely by regulation that nevertheless reduces the social cost of achieving the intended objectives of the regulation.
The critical task for modern tax policy is to balance the objectives of equity (ie, minimising regulatory arbitrage) whilst maximising efficiency. Only systemic tax reform which promotes tax linearity can synthesise these competing objectives.
Tax policy, risk transfer and financial arbitrage.
Enhancing national economic efficiency is a demonstrably rational response to changing demographic and economic conditions. The need to improve tax efficiency and neutrality is closely aligned to the task of improving economic efficiency. This means rethinking our attitudes to savings and investment vehicles such as synthetic equity, but really also requires a fundamental re-appraisal of our tax policy and technical legal attitudes to the savings and investment market generally. As this submission has suggested, central to this is a need to revitalise our attitude to risk, and to embrace the act of risk management as a central goal of improving economic prosperity.
It is the recognition that an investor’s wealth may be changed (added to or depleted, by the participation in a risky venture) that is at the heart of liberal market capitalism. Were it possible to earn positive income without risk, the finite amount of available property rights (or wealth) would quickly be re-distributed to all members of society, until they were equally shared between each of us. This would ignore the fact that each of us might desire more or less of a particular unit of property than other citizens, and the process of barter would develop to facilitate this transfer of property. Scarce commodities would become more valuable than non-scarce ones, and the process of barter would in that case be supplanted by individuals desiring more access to those scarce resources. When the concept of price and money develops, the process of wealth formation and risk transfer coincides with it.
Liberal market capitalism is legitimised by the observation that one way of allocating access to scarce resources is to allow the market to set the price for those resources, and for participants in that market to be driven by the profit motive. As scarce commodities are highly priced by the market, consumers of them will seek access to finance to assist in their purchase. The provision of finance is the purchase of risk, with the possibility of profit on sale (or redemption) of that risk as the incentive for its purchase.
Risk has traditionally been packaged as simple "debt" or "equity," but as the market matures the price, yield and profile on risk has become more closely defined. That is, the range of opportunities for the deployment and pricing of risk expands as the market becomes more sophisticated:
Financial innovations came about in part because of a wide array of new security designs, in part because of the advances in computer and telecommunications technology, and in part because of important advances in the theory of finance.
The differential pricing of risk is demonstrated by the various risk/reward possibilities which exist for the corner cases of simple debt or equity investments. Consider a Bank lending rate of 10%, with the deployment of the borrowed funds in the purchase of corporate stock. If the stock yields above 10% there will be "positive gearing," somewhat of a rarity. This is because the market sets the yield relationship. In the case of debt finance, the lender will receive back its initial advance, plus an amount of interest as compensation for being out of the use of the moneys advanced. The interest rate charged reflects the level of risk in the loan.
In the case of equity finance, both of the dividend and "principal" sums are at risk-the dividend is a function of profit and the election by the Board to pay it, and the initial investment can only be recouped if the share is sold at or above the original purchase price (or upon a liquidation/return of capital). Whilst the expected total return on equity finance is higher than that on debt (because of the risk differential) the realisation of the equity return is contingent upon the occurrence of future, contingent and risky events.
In fact, investment through debt or equity instruments are both simple examples of the process of sale and purchase of risk. The market and the process of financial innovation seeks to reduce the costs inherent in the risk transfer process:
The management of risk has traditionally focussed on capital. Equity capital is a wonderful "cushion" for absorbing risks of the institution. It is a wonderful, all purpose cushion. Why? Because management need not know what the source of the unanticipated loss is. They do not have to predict the source of loss, because equity protects the firm against all forms of risk: it is in that sense an all purpose cushion and thus it is very attractive for managing risk. As we all know, equity capital can be quite expensive for that reason. One can formally employ theories of agency cost, taxation and so forth to supply reasons why equity financing can be expensive.
The other fundamental means for controlling risk is through hedging. In contrast to equity capital which is still all-purpose, hedging is a form of risk control which is very targetted.
As human society seeks to expand economic prosperity, the markets turn to less expensive methods of risk management than those offered by simple debt or equity investment. This is the realm of financial innovation and derivative securities.
The benefits of the risk transfer mechanism.
The efficiency gains from the operation of the risk transfer process, and its modern manifestation, financial product innovation, have been suggested to flow from three driving forces. First, new products expand the opportunities for risk sharing by tailoring outcomes to individual investor requirements.
Secondly, new products may operate to lower transaction costs or increase liquidity: the total transaction costs for a delta hedged derivative exposure are less than for the purchase of the total amount of physical securities which the derivative relates to. Similarly, purchase of equity exposure through an equity swap may both lower transaction costs as well as increasing liquidity, when compared with the stock futures arbitrage it correlates to.
Thirdly, new products may reduce agency costs stemming from information asymmetries: derivatives reduce the possibility of negative portfolio price movement should future economic data prove to be inconsistent with present assumptions.
Arbitrage and the new issuance process.
Financial innovation offers price and profit outperformance possibilities which will be tend in the long run to be priced at equilibrium, removing those profit possibilities which drive the initial value of the innovation. In that case, the market will contain limited arbitrage opportunities (since they will all have been transacted away at fair values). At that point arbitrageurs will resort either to directional trading and price manipulation (eg consider the recent cases of the so-called "hedge-funds") to sustain profits, or will participate in further innovation, including through the new issuance market.
The expanded risk transfer possibilities which flow from new corporate issues of structured equity are clearly observable in the converting preference share ("CPS") market. One of the most spectacularly successful CPS was issued by TNT Limited in 1993. The proximity of the conversion price to the underlying ordinary share price meant that investors could realise value against the CPS by selling call options with a strike price equal to the CPS conversion price. For the seller this reduced its entry price into the CPS (itself a risk management strategy) and for the buyer of the call it provided risk exposure to TNT.
Since the valuation of the CPS indicated that the "embedded" call option in the CPS was effectively cost free, the seller of the call often was happy to transact below prevailing market prices for call options over TNT. Accordingly, as a result of the CPS issue, TNT benefited by raising new equity capital when the alternative ordinary stock issue was not possible (because of the corporate stress at TNT), and the market benefited from a new supply of cheap optionality and related risk transfer strategies. This increased the liquidity in TNT ordinary shares, as well as the value of those ordinary shares.
Accordingly, it is clear that financial product innovation offers three practical benefits to investors: to reduce risk by selling the source of it; to reduce risk by diversification; and to reduce risk by buying insurance against losses. Since the capacity of institutional product providers (typically investment banks and brokers) to innovate will be limited by the liquidity in the underlying physical market, it is important to enhance this liquidity by facilitating the introduction of new securities by corporate issuers. The restrictive Australian tax attitudes to structured and synthetic equity impact adversely on the new issuance market.
Financial innovation and the financial spiral effect.
The example of the TNT CPS is typical of the related derivative activity generated by properly structured CPS issues. Since the introduction of CPS in the early 1990s (the CPS market now has an aggregate issue size approaching $5 billion) CPS issues have provided a significant supply of new product, underpinning further financial engineering and hence the creation of additional risk transfer mechanisms.
Those CPS with conversion prices "close to the money" either at issue or during the life of the security have been integrated into mainstream arbitrage or risk management strategies, either to support "buy-write" trades or - typically where the delta of the CPS is in the range 0.4 to 0.6 - as part of switch strategies (involving a switch from physical shareholding to a CPS offering equity upside but downside protection through the conversion mechanism).
It will be observed that this process is consistent with the postulated "financial spiral effect": where the proliferation of new trading markets in securities makes possible the creation of new custom designed products improving market completeness. The new product ultimately becomes standardised, underpinning more product development - and so on. On this view, the markets spiral towards zero marginal transaction costs and dynamic completeness. To allow us to approach this perfect market, it is vital to ensure a regulatory regime which facilitates continuous product disaggregation and re-combination.
This explains why financial theory sees benefits in facilitating new security issues, because they add to the available stock of risk transfer tools available to investors. Concerning the importance of financial contract innovation to the expansion of the risk transfer process, finance theory proposes that innovation "completes the market":
In economics terminology, a securities market is complete if, and only if, for each state of the world there is a portfolio that yields a positive amount in that state and zero in all others. Each such portfolio provides insurance against a particular state occurring...the amount paid for an asset with a positive return in one state and zero in all others is equivalent to an insurance premium. The positive yield on that asset if the particular state occurs corresponds to the payment of an insurance claim when an insured event happens. If all states are insurable, it is easy to see why markets are called complete: an individual can protect against any contingency that might occur. Since the ability to pass risks on to those most willing to bear them is an important economic mission for capital markets, completeness is a desirable property.
Expanded understanding of the benefits of arbitrage.
To understand fully the value of efficient capital markets and financial product innovation, it is also necessary to comprehend the wider benefit of arbitrage to our community. One of the fundamental principles of arbitrage is that it allows securities which are mispriced against their fair value to be repriced by the arbitrage process. The mispricing can occur because of a distortion of the supply/demand calculus, generally because of a disparity between the market prices of functionally similar but legally different products, or products provided by differentially credit rated institutions. The value of arbitrage to the national or global wealth is a function of the enhanced liquidity promoted by the process, which combined with the actual mechanics of the arbitrage process leads to enhanced risk re-allocation possibilities for investors.
Arbitrage facilitates investment performance enhancement and risk re-allocation, and can easily be identified in markets where liquid traded options or futures exist. Financial innovation supports these socio-economic benefits where liquid markets do not exist, in those cases, the function of the listed derivative is performed by over-the-counter ("OTC") financial securities, which may either be simple or structured products. For example, the complex steps in stock/futures arbitrage may now be collapsed by transacting through the Over-the-Counter ("OTC") equity swap market, with lower transaction costs and quicker execution. This powerful opportunity has been effectively foreclosed in the Australian context as a result of the 1997 Budget measures!
In the case both of the simple arbitrage strategy and the structured equity swap it will be seen that the financial product innovation is consistent with the process described by Professor Alvin Warren of the Harvard Law School as defining the contemporary role of derivatives: they allow for disaggregation of traditional securities into their constituent parts; they facilitate the recombination of desired portions of those constituent parts into new products; and the financial function of the new products may provide for a risk re-allocation both to the product provider and the product purchasers.
But it is precisely these 3 powerful attributes of derivatives which introduces a chaotic tax outcome. The core problem faced by the Australian income tax in the area of new financial products is a result of the distinction it makes between debt and equity, and whilst this distinction has never been completely coherent, contemporary financial product innovation highlights that incoherence. The clearest example of this incoherence is the synthetic equity market, which despite its power in the US, is radically foreclosed in Australia, by the tax rules which this submission seeks the removal of.
C. THE BENEFITS OF TAX EFFICIENCY.
"Tax Efficiency," economic substance and national savings.
To increase our national competitiveness we must facilitate cost reduction and performance enhancement opportunities for our corporates and investors. This can be achieved by a facilitation of the risk transfer function of the financial markets and financial innovation. This not only requires a specific understanding of the financial attributes of the markets and the risk transfer function performed by them. The micro-level requirement for a rational tax response to new financial products, is the need to understand the financial efficiency drivers of the new products, which it is argued by their promoters make them commercially attractive. This task can only be performed in the context of taxation by inclusion of economic substance analysis at all levels of tax administration and collection.
The goal of improving the efficiency of business taxation is consistent with the policy foundations of the work of Dr. Vince FitzGerald on national savings. FitzGerald’s work addresses the issue of savings directly, (by proposing that private and public savings should be increased (and "dis-saving" decreased)), as well as indirectly, by reminding us that inefficiency is a species of dis-saving. In the context of tax, FitzGerald notes that as a minimum:
Creating a climate strongly conducive to productive investment, and encouraging a flow of domestic saving to finance it, involves not just providing a non-distorting taxation and low inflation environment but addressing a range of supply side factors. These include flexibility in the labour force, efficiently provided infrastructure, and so on...
The broad ranging proposals of the Fitzgerald Report coincide with the central theme of this submission. Restoring general tax neutrality and efficiency to the tax treatment of risk will provide an important facilitation to national savings. But a higher order task is required: by targetting tax efficiency gains directly at corporate capital raising and investment vehicles, the outcome of the RBT will operate precisely and directly to enhance and underpin national competitiveness.
This means that specific and facilitative tax reforms should be the goal of the RBT, particularly those which are capable of being delivered through systemic reform which will enable the removal of restrictive tax avoidance rules which fetter the market completing mechanism inherent in the risk transfer process.
By lowering the cost of capital to the firm, and facilitating enhanced investment structures, the facilitative business tax reform strategies outlined in Part II of this submission (including for corporate issued synthetic equity) will liberate the operation of the efficient capital market.
Streamlining the taxation of the capital market represents an important and rational response to changing demographics. Because it is politically impractical to increase taxes (except by stealth), and reductions to outlays are similarly impolitic, the facilitative response is an expression of a strategy similar to that proposed by FitzGerald, who calls for Government to "pursue policies that will increase productivity, or accelerate technological change, and thereby grow out of the current debt ratios".
Irrational tax reform, overly motivated by revenue sufficiency considerations, can not perform the task required to move us out of our current economic constraints. If we are progressing tax reform as part of the general micro-economic reform drive to improved efficiency, then to attempt to fashion a linear tax system by bludgeoning existing tax laws into an apparently homogeneous amalgam will be disastrous and inefficient. Systemic tax reform of the sort contemplated in the ASF paper is mandatory. The impossibility of achieving tax efficiency without systemic reform is clearly predicted by the leading US tax commentator, Prof. Jeff Strnad, who notes that achieving true tax neutrality (which he considers must involve "global pattern taxation"-more on this below) is not possible without wide-ranging and "systemic reform."
Tax Efficiency analysis.
The task of the RBT may usefully draw upon the innovative efficiency analysis of the 19th Century industrialist, Frederick Winslow Taylor. Taylor has been described by the doyen of management consultants, Peter F. Drucker, as being with Einstein and Freud, "one of the three seminal makers of the modern world."
The Taylor story neatly parallels the search for an appropriate control mechanism for taxation (and securities regulation) of innovative financial products. During the late 1880’s, Taylor had cajoled the skilled machinists in his Philadelphia steelworks to a doubling of their output. The cost of this increased output was a rebellious and unhappy workforce: Taylor reached the point where he considered resigning rather than face the hostile workers. The remedy Taylor hit upon was to engage in a scientific analysis of the process he was supervising. As a result of his experiments into the engineering aspects of locomotive construction, Taylor replaced the intuitive and inefficient practices of his contemporaries with a more precise and rational approach. Hours worked went down, whilst output went up. Prior to this turning point,
…much of their wisdom was guesswork, built up over the years into serviceable rules of thumb…For them informed guesses were good enough…Traditional craft know-how, reduced to scientific data, was passing from workman to manager, from shop floor to front office.
"Taylorism" is now described as "… the application of scientific methods to the problem of obtaining maximum efficiency in industrial work or the like."
The Tax ReValue method proposed in this submission, and which is elaborated upon below, advocates "outing" the financial modelling which sophisticated investors use to evaluate financial products. The benefits to tax policy and administration of an adoption of this approach are numerous. The approach tells us:
International attitudes to Tax Efficiency.
The Government’s desire to boost micro-economic efficiency and national savings should encourage a regulatory approach which facilitates efficient new financial products. This vital objective is clearly a primary goal of the RBT, and is evident in the statement in the ASF paper that:
…a vital precondition for international competitiveness will be to ensure that the business tax system does not influence business decisions unnecessarily. In particular the business tax system should not make Australia an unattractive location for inbound investment, nor drive existing domestic investment offshore purely on the basis of tax considerations.
To assist the move to an efficient and competitive market, some international benchmarking is required. For example, we must acknowledge that financial engineering is recognised in our major trading partners as totally consistent with the normal operation of an efficient capital market. Rather than being the hallmark of tax arbitrage, financial innovation is often the vehicle for improved financial efficiency. Speaking of the North American experience, it has been said that:
…in addition to derivatives, participants may use tools called "structuring techniques" often in combination with derivatives, to exploit anomalies in the market. Investment bankers, working with clients to raise money, use structuring techniques to convert one set of risk/return relationships into a different set of risk/return relationships often involving the issuance of new securities. By decomposing risks and returns into component parts, they can then repackage those risks and returns to make them more appealing to different segments of the investor market. In the process, they use the resulting savings to lower the costs of raising money to the issuer and to increase their own returns. Investment bankers also use structuring techniques with investors to increase the returns on their assets without increasing their risks.
This role of derivatives exposes the difficulty for a tax system which gives certain tax benefits to equity and others to debt. The modern approach to investment is to break up or "unbundle" the equity investment into separate components, to retain those desired by the investor, and to sell off the residue using the derivative market. The basis of the contemporary risk management approach to disaggregation of equity risk, is the recognition by corporate finance theory that the value of the firm is dynamic, and reflects the multitude of risks assumed by the firm.
Measuring Tax Efficiency.
Efficiency of regulatory outcome can be notoriously difficult to measure, and the common intuitive response is to lampoon financial engineering as mere paper shuffling. Nevertheless, our financial markets are adept at measuring the real value of structured or synthetic equity derivatives. Financial analysts customarily allocate value by benchmarking a new issue of a structured equity derivative against the corporate issuer’s existing cost of capital, or by comparing the return on a synthetic against that available for securities offering comparable investment exposure.
For example, many of the CPS issues of the early 1990’s were earnings per share positive: either absolutely, or compared to alternative equity raising methods, such as discounted rights issues. Combined with this financial efficiency at the issuer level was the attractive investment profile which the capital protection, enhanced yield, and equity upside provided to investors. These investment attributes of converting preference shares offer a trifecta of benefits which are common to most synthetics and which operate in a range of circumstances:
Synthetics truly display the risk transfer features, and benefits, of the financial arbitrage function.
Although efficiency considerations are a cornerstone of tax policy, the level of inquiry in the area of innovative financial products is relatively unsophisticated. The search for efficiency is most unhelpfully hindered by the confusion of legitimate tax system design objectives (equity, efficiency) with a purely political concern about sufficiency of revenue. The sufficiency concern is properly about tax rate levels, and should not be allowed to distort tax system design to capture additional tax revenue by stealth.
Tax revenue sufficiency as a secondary goal of tax policy.
When tax system design is primarily driven by questions of revenue sufficiency, as in "how do we collect more tax revenue without actually raising tax rates?" the prospects for rational reform quickly disappear. The only coherent basis for tax system design is to ensure consistency and universality and then to align rates to expenditure.
An increase of business tax levels (including through the proxy for direct taxation-the denial of tax benefits where risk is managed) is not only against the global trend, but is also aligned with a more fundamental pessimism about liberal market economics. These essentially anti-Business ruminations express anti-liberal economic concepts of the sort labelled by the MIT Economist Paul Krugman as the false doctrine of "Global Glut." In his critique of this phenomenon, Krugman suggests that it is characterised by the belief that:
Capitalism is too productive for its own good-that thanks to rapid technological progress and the spread of industrialisation to newly emerging economies, the ability to do work has expanded faster than the amount of work to be done.
In a nutshell, Krugman argues that rather than causing the high unemployment which characterises Western European economies such as France, global capitalism is a stimulator of prosperity, and that the primary cause of low prosperity is inefficient regulatory and taxation systems.
Enhancing efficiency in the savings and investment market, in particular by facilitating the use by investors of contemporary risk management techniques made available by derivative products (including synthetic equity), is a vital response to the rapidly changing global and national marketplace. This approach will allow financial innovation (including the use of "synthetic" structures) to deliver two key benefits: enhanced investment returns (which will support increased savings); and cheaper capital for our business entities (boosting productivity, growth and employment).
Tax efficiency and the debt/equity distinction.
Tax inefficiency proliferates in investment capital taxation. Just as the dominant trend in the taxation of risk managed equity positions is to deny the equity tax benefits, the current approach to the taxation of risk managed debt is to deny or limit the interest deduction claimed where the position is funded by external debt.
Because of the different risk in equity finance, the valuation of equity investment takes into account a different range of considerations than that for debt finance. For example, the yield is only one factor for the consideration of an equity investor. The possibility of profit is another, equally important factor. Simple equity valuation techniques such as price/earnings multiples or discounted cash flows, measure the value of the company based on the propensity of an investment in it to pay back to the investor the amount of its purchase price, over a given period. For a high risk company the required pay back period is low and vice versa. The point after which the investor has been paid back is the beginning of the period in which the investor begins to enjoy its profit.
In the case of the Bank lending rate of 10%, an investor will normally find it prudent to use borrowed funds to purchase stock if the yield is below 10% but the p/e or dcf valuation predicts that a net profit will obtain during the selected investment horizon. For example, if the present equity yield is 5%, the investor will be rational if it purchases that stock using borrowed moneys under a scenario where it is reasonably likely that the yield will grow to the point where the prospect of gain is real. Since the p/e or dcf methods are the usual equity valuation techniques, the market will reward a growing yield by re-rating the face value of the stock. Either the geared investor sells the stock at a profit (assessable, either on capital or income account) or it retains the stock but retires the borrowing early (and again is in a tax payable scenario when the stock is sold). This is, after all, what cases such as Ure (Ure v FC of T 81 ATC 4100) are all about.
Gearing, risk management and income tax policy.
We may pause for a moment to examine the commercial bona fides of the "Geared Equity Loan" and the Instalment Warrant (a synthetic replication of the Instalment Receipt). The first is an extension of high margin lending by Banks which are willing and capable to take equity risk. Typically such lenders hold stocks in their equity derivative trading books, which holdings are ultimately funded by shareholder’s capital or external borrowings.
The risk assessment which supports those holdings is simply extrapolated to the provision of finance to external borrowers through non-recourse "Geared Equity Loans." In the case of Instalment Warrants, the investor pays an initial warrant premium of approximately 50% of the initial share purchase price, plus an amount representing pre-paid interest, and is truly at risk in relation to that initial premium. That is, if the stock drops below that initial premium, the investor will have lost that amount (because it will be dis-economic to pay the second instalment). This is the same type of risk assumed by the "Geared Equity" investor - the stock must appreciate by at least the amount of the initial interest payment for the asset to be "in the money."
Although both products offer clear efficiency benefits, the tax profile of each is currently under ATO review. Since this ATO review is proceeding on the assumption that subjective taxpayer purpose is relevant to the issue of deductibility under the first limb of (old) s. 51 (1) Tax Act (now s. 8-1 (2) 1997 Tax Act ), it is clear that the multiple characterisation approach is alive and well in core areas of our business tax system. Every taxpayer will have a different subjective purpose for entry into a business transaction!
With respect, the correct view is that the essence of deductibility of interest payments is the participation, with borrowed moneys, in a profit making venture. Finance theory and reality links profit potential with risk, and hence we see once again that the vital issue for a modern tax policy is to understand the role of risk minimisation. Financial arbitrage is nothing more than the transfer of risk to another market participant who is willing to assume it (for a price), but in such a fashion that the profit potential (albeit at reduced levels, because of the price of the risk transfer) is retained by the investor. A perfect market exists where it is possible to "insure" against all possible outcomes, such that the return on an asset is positive in one state but neutral in all others. In the case of the investment in stock using borrowed moneys it is not the minimisation of risk that should or will of itself deny the deduction, it is the transfer of all possibility of profit as well that should cause the tax deduction to be denied.
Thus when we analyse geared stock positions we should question the expense of the risk minimisation, and be particularly concerned where the probable rate of return on the asset is negative or zero in all realistic market scenarios. Against this benchmark it will be seen that the existing geared or protected equity products are normally profit producing, and hence the deduction for interest is proper and sustainable. The current ATO attack on interest deductibility is often no more than a proxy for a direct increase of tax rates, but the means adopted is significantly less efficient that a direct rate increase.
The concern here is now aggravated by the recent statement by the High Court of Australia, which questioned the availability of an interest deduction where the borrowed moneys were used to strengthen the "structure" of the company: since money is fungible, the statement has ignited significant taxpayer and lender concern:
If the (borrowed) funds are to be used as working capital, the cost of the discounts will be deductible as a revenue expense…If the funds are to be used to strengthen "the business entity, structure or organisation set up or established for the earning of profit" the cost of the discounts will generally not be deductible because they will be a capital, and not a revenue expense…
The ATO response to this uncertain characterisation based problem has been to issue a statement indicating that it will not follow the High Court’s position in this area:
…we would at present regard the High Court’s comments in ERA concerning when discount expense is capital in nature as being very much limited to its facts.
Despite this administrative position of the ATO, its recent decision to challenge the deductibility of interest for protected equity loans compounds the uncertainty in this area. This uncertainty has prompted a leading Australian tax counsel to comment that:
…that there might be a different characterisation…for interest…is a matter which calls into question the Australian system’s performance against the hallmarks of equity, efficiency and simplicity.
In relation to the apparently vexed issue of interest deductibility in the US a leading US tax academic has stated that:
The two decades of experience with these laws suggest great caution in attempting to enact solutions that require the recharacterization of debt as equity or that attempt to limit a disallowance of interest to indebtedness incurred for a particular purpose, such as a hostile (or even any) takeover. The past two decades also teach that there is little gain and no stability to be had from such marginal tinkering as opposed to beginning to address the underlying fundamental income tax problems. One cannot help but wonder where we would be today if Congress in 1969 or even in 1978 -- when Congressman Ullman, then chair of the House Ways and Means Committee, advanced such a proposal -- had begun to phase in an integrated corporate tax that eliminated, or at least narrowed, the corporate income tax treatment of debt and equity.
The issue of deductibility of interest for financial accommodation provided to assist the purchase of equity is linked to the (yet unexplored question) of deductibility of interest on funds borrowed to purchase synthetic equity. This is a problem which is linked to the capital/income distinction, and illustrates the need for careful thinking about the optimal tax policy response to these issues. Simple denial or limitation of the deduction, perhaps in conjunction with an expansion of the concept of capital type transactions to cover risk managed positions, would clearly be a sub – optimal approach.
The convertible note/deductible equity problem.
Another obvious discontinuity in the taxation of investment capital concerns the treatment of convertible notes and deductible equity. It is important that the RBT should recognise, and respond to the inefficiency in our current approach to convertible debt/deductible equity. The inefficiency is manifest in the issuance of deductible equity securities in the US market by many of our top corporates (which would not be possible in the Australian market under our current tax rules). The convertible is the flip side of synthetic equity, with the tax benefit under the former (ie the interest deduction) analogous to the tax benefit under the latter (ie the franking credit/dividend rebate).
Convertible notes enjoyed some popularity as tax effective quasi-equity instruments under the Australian classical or double tax corporate tax regime. The interest deduction offered a tax shield, which was attractive in lieu of dividend tax relief under the non – integrated, pre - imputation tax system. In response, the ATO introduced a series of restrictive tax measures (non – compliance with which will deny interest deductibility) which were designed to reduce the commercial and tax advantages of the convertible note. Since the introduction of dividend imputation the rationale for the current tax treatment of convertible notes has disappeared. The measures rely on a characterisation based approach:
The Australian approach to the problem of convertibles may be characterised as an objective one. There is no attempt to look beyond the technical terms of the note and to distinguish the financial reality behind the transaction. Simply, notes that comply with the terms of Div. 3 A of the ITAA will be treated as debt, and those that don’t, as equity. Yet, if the distinction between debt and equity is to remain important (and the widely differing taxation treatment would suggest that it is), should not the commercial "reality" be a consideration?
Although it would no doubt be an improvement on the current situation, it is unlikely that a simple financial analysis of convertible notes would resolve marginal concerns, and in this regard we are left with the observation that systemic reform of investment capital taxation (including by a removal of the convertible note rules) will assist tax linearity in debt and synthetic debt markets, as well as in the equity and synthetic equity markets.
The non – linearity in the tax treatment of convertible notes has the propensity to impose financial inefficiency on these important securities. By reducing the financial benefits of convertible notes through the prescriptive tax treatment erected by sec. 82 SA Tax Act the important financial efficiencies available will be curtailed. These efficiencies include capital cost and investor return enhancements, as well as the important signalling benefits which a debt or quasi – debt instrument offers:
Consider the case of a firm that wishes to invest in a new project and issues new (equity) securities to do so. If information is symmetric, this issuance should have no price impact. The outsiders know about the new investment and know that firm’s prospects dictate that the firm must raise outside money to pursue it. In fact, the issuance of most types of (equity) securities results in negative abnormal returns to the company’s stock. A common explanation for this phenomenon is information asymmetry: Insiders know more about the firm’s earning prospects than outsider investors, and these investors are aware of that fact. Raising funds by issuing (equity) securities is costly, and insiders would not do so unless they expect there is a significant chance that internally generated funds will not pay for the investments. Thus, issuing (equity) securities to raise funds signals negative information about the future earnings prospects of existing firm operations…Empirical studies consistently find that issuing equity results in significantly more abnormal negative returns than issuing convertible debt.
This analysis illustrates that the cheaper capital costs which are available through a convertible issuance program are linked to the signal which a debt or quasi – debt issue delivers to the market about the financial health of the firm. Tax laws which intrude on this signalling mechanism are sub – optimal, and should be removed.
D. THE NEW PARADIGM: SYNTHETIC FINANCIAL PRODUCTS.
Risk management and the synthetic issuance process.
Aligned with the expansion of risk management technology is the rapidly increasing trend in the issuance, and use by investors, of synthetic equity products, which often forego an element of equity upside in return for some capital protection, or increased yield. The more sophisticated synthetic equity products are based on probability analysis of future market expectations. Accordingly, if an investment model forecasts that a given share or index price is not likely to appreciate more than a certain amount, but that there is also the likelihood of a drop in price, it may often be cheaper to invest in a synthetic security. This is because the synthetic security is a financial arbitrage vehicle: the issuer of the synthetic will take a view contrary to the investor, for example, that the downside risk potential is less, or the upside profit potential is more, than the level expected by the investor.
These products also offer scope for reduction of market impact, which may otherwise harm a simple asset allocation investment strategy. For example, the purchaser of the synthetic equity product may "buy" the equity exposure at market prices, not at the premium to market which a physical purchase of large volumes of the specified shares, basket or index might entail. This is because the issuer of the synthetic product can do so "unhedged," ie it will cover its exposure gradually and subsequently, perhaps at a profit to it. Accordingly, synthetic equity offers the risk transfer potential which is the key value driver of all arbitrage transactions.
These trends have been identified as the key features in the development of the synthetic equity market. Commenting on the use of synthetic equity in contemporary portfolios (particularly in the case of the US, an important benchmark for Australian business tax reform), it has been noted that:
In relation to the equity market, the investment strategy of these investors is focused on purchasing shares in order to create a portfolio that replicate the return on an index. The trend towards index replication is also enhanced by the process of investment performance evaluation whereby investment returns are measured relative to the performance of the benchmark index. (Synthetic equity instruments) are particularly suitable for this type of investment strategy as they facilitate the purchase of an entire index with a single transaction.
Growth of synthetic securities
Synthetic equity products are a global phenomenon, popular because of the benefits they offer to issuers and investors. In 1995, speaking of the US experience, Daniel L Hutchinson of Morgan Stanley and Co described these benefits:
With the combination of record high equity values producing low dividend yields, sustained low interest rates, tight spreads and a paucity of high yield equity, investor appetite for yield enhanced equity has become an increasingly significant factor in the new issue market... Since 1991 there have been 60 offerings of (synthetic equity such as) PERCS, DECS and similar securities... Driven primarily by issuers’ capital and rating requirements, but successful because of investors sustained willingness to forgo a certain amount of equity upside in exchange for higher current income.
It was suggested above that the social good of risk re-allocation utilising derivative contracts provides momentum for a positive attitude towards financial product innovation. The process of risk management through structuring must be facilitated both for intermediaries (ie, the marketplace) and for intending corporate issuers (ie, at the level of the firm).
The need for a facilitative framework for corporate issuers has been verified by worked examples of the role of structured derivative products in reducing the cost of capital of a firm. Corporate issuers of synthetic equity products avail themselves of the cheaper cost of capital offered by these instruments. This trend has been documented in the context of the popularity in the US market of so called "interstitial securities". These instruments are really synthetic equity products which offer a customised risk/reward profile to investors. In the US market there has been in excess of US $55 billion worth of synthetic equity issues by corporations since 1991. In Australia the leading example of corporate issued synthetic equity is the converting preference share. Since 1990 there has been in excess of $5 billion worth of converting preference share issues in Australia, including from such leading corporates as Westpac, News Ltd, ANZ, Coles Myer, and TNT.
Synthetics in the retail savings market.
If these remarks are valid at the wholesale level, they are also becoming true for retail investors. An emerging trend is for retail investors to take a more active role in construction of their personal investment portfolio. This trend is very noticeable in the widespread popularity of specific purpose "mutual funds" in the US retail market. In Australia, the self-help approach is driven largely by the observed under-performance of many of the balanced or managed superannuation funds, compared to the industry benchmark (the "All Ordinaries Index"). The rapid growth of the Australian warrant market (which now includes structured warrants such as Endowment Warrants and Instalment Warrants) and the popularity of protected or geared equity lending structures is evidence of the emerging trend for self-control of investment decisions by the retail market. Retail investors use synthetic equity products for many of the same reasons as their wholesale counterparts:
A major factor underpinning the development of these types of transactions in equity markets is the capacity to customise the pattern of returns from the relevant investment. (Investors) can utilise these specially tailored structures to position portfolios to profit from anticipated moves in equity market values...
Inside the synthetic investment process.
A contemporary example of the benefits which such products can provide to non-sophisticated investors is in the Instalment Receipts used by the Commonwealth Government to sell down its last 30% in the CBA, and currently being used as part of the process of selling 30% of Telstra. These securities are being replicated by intermediaries, who are issuing similar products over other shares. They are extremely popular, because of the gearing and lower risk profile they provide.
The shares are placed into, or are held by the intermediary on, trust for the ultimate purchaser. The purchaser pays an initial instalment (say 50% of the current price) plus an amount by way of interest. Because the stock is held in or on trust, the IR purchaser receives the dividends and attached franking credits. In the case of Telstra, this process means that an initial outlay of around $400 will secure an investor access to the minimum subscription level offered through the float. This trend is part of the growth in direct share ownership levels being reported by the ASX (up from 14% adult Australians in 1991 to 34% in 1997, with a total of 40.4% Australians currently holding a direct or indirect interest in shares). This can only be beneficial to the level of national savings, and is the clearest possible evidence that trusts, negative gearing, and structured equity products are both Government sanctioned (albeit perhaps unknowingly), and increasingly part of the normal financial life of "Mainstream Australians."
Despite the success of the Instalment Receipt market, the Australian tax attitude to financial innovation is still characterised by the absence of many of the important new securities which can be observed in vibrant markets such as the US.
E. THE ROLE OF ECONOMIC SUBSTANCE IN BUSINESS TAXATION.
Using financial analysis to assist tax system design.
Tax system design literature suggests that the analytical problems posed for the tax administration of synthetic equity securities can be resolved by application of financial analysis. Derivatives are just as much a creature of financial analysis as they are of regulation (and in fact, arguably they should not be shaped - at least in a financial sense - by regulation).
Much of the US financial product literature displays a fascination with "contingent debt" - ie. securities with a debt like financial profile but with returns also linked to the outcome of events contingent to the security, such as the performance of an equity, index or commodity. The US tendency is to package equity exposure as debt, to secure tax deductibility for the "interest" component in the security. This is in order to lower the tax profile of the security below the non-deductible/assessable status of equity, which results from the non-integrated or "classical" corporate tax system prevailing in the US. Because of the tax arbitrage possibilities in the US equity linked debt market, the US analysis of contingent debt raises similar issues as for synthetic equity in Australia.
The search for a linear tax approach to equity derivative securities should not thwart their disaggregative/recombinative power. Financial product innovation is justified by the efficiency gains delivered, by providing a lower cost of capital at the level of the firm, and by expanding the range of risk transfer mechanisms available to the market.
Understanding the role of market completeness and the use of derivatives exposes the double edged sword which tax administrators struggle with in the area of hybrid debt/equity products: a security may display certain equity characteristics which its designers argue should attract the equity tax benefits (rebate/franking) to it. The security may also be, and typically is, part of a portfolio which is managed so that some or all of that equity risk is transferred elsewhere.
Finance theory argues that the use of derivatives to disaggregate and recombine positions to reach an optimal risk/reward portfolio is valid and good. The converse is also true: tax administrators struggle to design a coherent and rational analytical framework, to delineate acceptable market completing or risk transfer products and structures, from those which are "unacceptable" tax avoidance. Cutting through this task is the difficulty posed by tax arbitrage.
Economic analysis is a central tool for allowing us to evaluate whether a transaction is unacceptable tax avoidance, or whether it is an acceptable financial innovation. Nevertheless, systemic reform of the framework of investment capital taxation is necessary before we can tax efficiency through this liberate economic analysis. That is, we need to remove the artificial distinctions and differentiations in our current tax laws.
Modigliani – Miller and the risk/return calculus.
The work of Modigliani and Miller reminds us of the importance of effective financial analysis of corporate and investment activity. Their initial work demonstrated that the value of the firm is fundamentally derived from the value of its underlying activities, and that this value is a function of the level of risk and the level of returns derived from those activities. In their analysis of the valuation of shares they made their seminal statement that the:
…current valuation is unaffected by differences in dividend payments in any future period and thus that dividend policy is irrelevant for the determination of market prices, given investment policy.
This statement accords with their proposition that the capital structure of the firm is irrelevant to the wealth of the firm, other than as a result of taxes which apply differentially to the capital components of the firm. They prove that the fundamental determinant of the wealth of the firm in uncertain market conditions is driven by the investment policy of the firm, and that the capital structure is irrelevant to that wealth (other than through taxes):
…(In) the certainty world, in which as we know, firms can have, in effect, only two alternative sources of funds: retained earnings or stock issues. In an uncertain world, however, there is the additional financing possibility of debt issues. The question naturally arises, therefore, as to whether the conclusion about irrelevance remains valid even in the presence of debt financing, particularly since there may well be interactions between debt policy and dividend policy. The answer is that it does…The return to the original investors taken as a whole – and remember that any individual always has the option of buying a proportional share of both the equity and the debt – must correspondingly be broadened to allow for the interest on the debt…The net result is that both the dividend component and the interest component of total earnings will cancel out making the relevant (total) return, as before,…clearly independent of the dividend policy given investment policy.
This concept is important to this submission on several levels. First, it acknowledges that in a certain world, ie a world without risk, profit possibilities derived from risk taking do not exist. This explains the absence in such a world of demand for and supply of debt finance, since lenders and investors do not enjoy additional risk based returns and hence underatke investments directly. Absence of risk would coincide with abundance of resources, so that citizens desiring access to one resource would sell or barter resources to which they have ready access, to provide funds for purchase of those other resources which they desire.
The corollary of this position is that a world in which debt finance exists is a risky world: the management of that risk is precisely the rational response to the human condition which, in the field of financial innovation, drives the arbitrage market:
The recognition of risk management as a practical art rests on a simple cliché with the most profound consequences: when our world was created, nobody remembered to include certainty. We are never certain; we are always ignorant to some degree…the essence of risk management lies in maximising the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between cause and effect is hidden from us.
Since we are in a risky world which enjoys access both to debt and equity finance, the clear need is for our tax system to finally embrace the financial reality, that debt and equity should not artificially be differentiated between.
Parallel provisions: the source of tax non – linearity.
Because of the fundamental impact the debate about taxation of investment capital has on the way we save and the way Australian companies access capital, it has started to arouse intense interest in the Australian community. Nevertheless, given even the current levels of scrutiny, it is surprising that the real issues behind the reform push have not clearly been articulated. The perception that the tax changes proposed to innovative financial contracts are simply about consolidation of, and protection of revenue collected through, the existing tax system, is only partially correct. The rhetoric of anti-avoidance and tax neutrality might be politically helpful, but it disguises the more fundamental and vitally important tax reform work that this re-appraisal of the taxation of investment capital should embrace.
The relationship of tax laws to economic activity – and particularly the role of incoherent tax laws (such as those which artificially differentiate between debt and equity, and capital and income) and economic inefficiency – has long been a subject of tax policy analysis. In his commentary on the role of corporate debt finance and the leveraged buyout boom in the US market in the late 1980’s, Professor Michael J Graetz of the Yale Law School lamented the role of the differential tax benefit available in the US for debt finance, and the surge of LBO’s:
From both an immediate and a longer term, or structural, perspective of the corporate income tax, the most serious problem seems to be the long-lamented fact that the tax burden on income earned by a corporation and distributed to shareholders as dividends bears a heavier tax burden than corporate income distributed in other forms or to other suppliers of capital -- most importantly, amounts distributed to bondholders as interest. Unlike dividends, interest is deductible at the corporate level and, therefore, bears no corporate income tax. This disparity creates tax incentives for raising corporate capital through debt rather than equity and for substituting debt for equity. I have not seen the figures for 1988, but during the period 1984 through 1987, corporate equity apparently decreased by more than $ 300 billion, while corporate debt increased in excess of $ 600 billion. These numbers alone obviously portend major revenue effects from substitutions of corporate debt for equity and, potentially, from restructuring the corporate income tax law…I continue to believe, however, that the core of the tax problem lies in the age-old corporate tax distinction between debt and equity, rather than in the removal of assets from corporate solution.
Tax policy which fails to accommodate the taking and minimisation of risk will accordingly be adrift from the actual manner in which society orders itself and conducts its affairs: it will be a truly irrational and incoherent tax policy. This has vital implications for the tax treatment of risk managed debt and equity positions, as well as for the broader reconstruction of our system of investment capital taxation.
In fact, the observation of tax non – linearity, typically expressed through a tax regime which contains multiple or parallel provisions, producing markedly different tax results for the same or approximately identical transactions, is a typical sign of an incoherent tax policy, ie a tax policy which does not accord with and provide a fair and neutral outcome for the typical transactions which taxpayers engage in.
To assist in formulation of a linear tax policy response to financial transactions and products, we should seek the removal of specific tax provisions in which non – linearity may be seen as an indicator of structural tax policy weakness. This submission is focussed on the tax treatment of risk managed or risk transfer positions, and suggests the removal of:
Consistent with the theme of this submission, and the approach of the RBT, that systemic tax reform is required to achieve the key national objectives of economic competitiveness, tax law simplicity and revenue sufficiency, it is suggested that the removal of the debt/equity distinction may be achieved through introduction of a system of "Franked Debt." Introduction of such a system will facilitate the removal of each of the offensive tax rules identified above. Whilst it is clear that the debt/equity distinction is at the core or these incoherent tax laws, we should also note the potential uncertainty and inefficiency established by the capital/income distinction. The discussion which follows will support the proposition that one of the key weaknesses in our tax system is the existence of a differential tax treatment for functionally equivalent transactions, including debt and equity, and capital and income.
The differentiated tax system.
The M – M thesis provides, as we have seen, a mathematical verification of the essential fungibility of debt and equity, and the irrelevance of the composition of a firm’s balance sheet (ie the debt/equity mix) to the wealth of the firm:
…the market value of any firm is independent of its capital structure and is given by capitalising its expected return at the rate pä appropriate to its class.
The thesis was, of course, subject to the famous correction, which noted that the universality of the statement was subject to the existence of tax, and particularly the tax distortion caused by the differential tax treatment accorded to debt and equity:
…it can be shown…that "arbitrage" will make values within any class a function not only of expected after – tax returns, but of the tax rate and the degree of leverage.
The differential tax treatment of debt and equity is a source of non – linearity in tax policy and practice. The current tax administrative approach to this differentiation is evident in the structure of the 1997 Budget measures and TOFA. Both seek to deny equity tax benefits where risk is transferred, such that the financial profile of an equity position is aligned to that of a simple debt position. In this regard, the reform measures proposed by the ATO and Treasury may be seen as a proxy tax on risk management itself, see TOFA:
…when a taxpayer enters into an arrangement to substantially remove the opportunities for gain and the risk of loss from a share, the taxpayer be denied the franking credit and dividend rebate on dividends on the share;
and the 1997 Budget measures:
…the benefits of the franking credits would only be available to the true economic owners of shares…
The current anti-avoidance approach of the ATO is thus to deny the equity tax benefits on a risk managed position. This is difficult to reconcile with the stated policy objectives of, for example, TOFA, which suggests that it is driven by the need for increased linearity:
(TOFA) seeks to improve determinacy and neutrality within the risk classes embedded within the tax system. This is intended to interfere to the smallest extent possible with financial innovation, while seeking to preserve the basic foundations and integrity of the tax system, as evident in the statement that:
A principal tax policy issue in dealing with synthetic replication is to accommodate and not impede financial innovation while at the same time ensuring that the basic design features of the business tax system are not eroded. In particular, one requirement in this area is to prevent undue tax deferral and tax arbitrage through the risk transformation process…
A tax policy response which focusses on the act of risk management as a trigger for tax is inconsistent with the legitimate concerns of investors to manage that risk. This is particularly so in capital importing countries such as Australia, a point acknowledged by the Federal Treasury:
Global integration, financial innovation, and regulatory reform (including financial deregulation and financial taxation reform) impact on one another as components of a larger adjustment process…It is important therefore that decision – makers be cognisant of the impacts and significance of this adjustment process. This is particularly the case in respect of small, liberalised capital importing countries (like Australia) which have been subject to substantial volatility in their terms of trade, the exchange rate and financial asset prices.
The Capital/Income problem.
The tax differentiation problem intrudes into the tax policy confusion surrounding the capital/income distinction, which is most clearly observed in the often difficult question of interest deductibility. The provision which causes concern is sec. 8- 1 (1) Tax Act (1997) (ie the successor to sec. 51 (1) under the 1936 Tax Act). We have illustrated the concern in relation to the tax treatment of interest on borrowed moneys used to purchase shares, and especially where the terms of the financing contemplate limited risk for the borrower. As we have seen, the tax policy confusion here is embedded in the question of whether part of the interest in this case is attributable to a transaction on capital account, and hence not properly deductible?
The ingredients of tax linearity: "Global Pattern Taxation".
Optimal capital market tax policy is an elusive goal. Tax policy commentators such as Strnad and Warren identify conceptual and practical shortcomings in the simple unbundling of financial assets approach to taxation of financial transactions, such as the bifurcation and integration approach. Similarly, the imposition of a discrete new tax regime only for financial products has also been critiscised by Strnad, who suggests that this "local pattern taxation" approach artificially segments existing from new products, and is ultimately unhelpful to the quest for tax linearity.. He is left supporting "global pattern taxation" as the normative or ideal tax policy approach:
Global pattern taxation is the only one of the four general approaches that can achieve consistency and universality without an obvious operational or conceptual flaw. But because implementation of global pattern taxation would require systemic reform, this fact is of little comfort to administrators who must craft rules in a system arrayed with different tax tax treatments that must be taken as given.
This comment suggests the source of the difficulty which confronts TOFA and the 1997 Budget measures. Without systemic reform of the taxation of investment capital, tax linearity will be impossible to achieve. The clarity of this statement is observed when we attempt to produce linearity at the debt/equity boundary: within a differentiated tax system which provides non-identical tax benefits for debt and equity products, or derivatives thereof, absolute universality will not be achievable.
In particular, when the gateway for the attempted denial of tax benefits is opened simply because the investor utilises risk management techniques, which are often verifiable as "bona fide" on the basis of accepted financial market strategies, the dominant result will be inefficiency and incoherence. It is precisely this inefficiency which the modifications to the original Budget measures (expressed in Treasurer’s Press Release 89 of 1997) sought to avoid. The existence of those modifications is contemporary evidence of the awareness Australian Revenue authorities have that tax reform must be systemic and bold, rather than piece meal and ad-hoc, in order to be rational, coherent and efficiency enhancing.
The possible circularity of the current tax reform debate is thus exposed. If the driving force is enhanced efficiency, productivity and employment, then it is less than rational to seek to achieve those goods by constraining the growth of productive capacity by introducing tax distortions into the investment capital markets.
National competiveness and tax arbitrage.
This submission has illustrated the need for a focus on national competitiveness by consideration of the current negative tax treatment of financial products. Because the current tax outcome for these products is often incoherent, the Australian market continues to experience aggressive tax reform measures. Many of them are designed to streamline the tax treatment of products in this area, in an effort to reduce discontinuity, non-linearity and tax arbitrage.
These (largely incoherent) tax reforms highlight the negative effect of tax arbitrage, that it actually circumvents efficiency in the market, to the detriment both of taxpayers and tax administrators. Many tax administrators, practitioners and financial market participants will have seen at some stage in their careers examples of the "dead hand" of archaic legislation. In the US experience this can be observed in comments such as the following, which I suspect can readily be echoed here:
In many cases, economically rational transactions are not entered into for fear of tax costs disproportionate to economic returns. In other cases-in my own experience much less common than tax policy makers typically believe-taxpayers can use the current approach to the tax analysis of complex financial instruments to produce…after tax results superior to more straightforward transactions. In either case, the current tax system distorts the capital markets.
And yet despite the perceived revenue sufficiency and taxpayer equity needs driving many of the detailed measures in recent tax reform proposals, there is a missing ingredient - what is the basis upon which analysis of economic efficiency is actually available, to determine the tax outcome of a questionable product or transaction? The absence of this sort of inquiry means that the other tenet of tax system design – efficiency - is not satisfied; and it is to the reversal of this trend that we now return.
Economic equivalence and tax policy.
The essential ingredients of a rational tax system are that it is both equitable and efficient. Concerning equity, it is clear that this means on a pre-tax basis, and this view is certainly reinforced by any reasoned analysis of the essential ingredients of tax arbitrage. An elegant general analysis of tax arbitrage is that it:
…violates consistency because it is equivalent, in cash flow terms, to doing nothing, and the usual result for a taxpayer who does not engage in any transactions is that there are no tax consequences…Tax arbitrage arises in its purest form when a series of transactions results in no net cash flow but provides tax advantages.
Kleinbard confirms that the correct measurement of financial innovation is on a pre-tax basis:
…the tax system should respond to financial innovation by promptly formulating clear substantive tax rules that produce after tax results commensurate with each new product’s pre-tax economics.
Before we can map out a framework for this analysis, however, we need to settle the jurisprudential basis of the inclusion of economic evidence - of any sort - in Australian judicial proceedings. If we simply believe that judges will altruistically follow this sort of inquiry just because they are able, or directed, to do so, then we may be sadly mistaken!
Economic analysis and judicial decay.
In his excellent overview of the various theoretical strands which make up tax jurisprudence, the Canadian scholar Neil Brooks states the initial premiss of his thesis, that:
…the people who are often not mentioned in the indictment of our tax laws…but in my view who are more blameworthy than any of the others for the mess we find ourselves in – even more so than tax professors – are judges. Generally, judges have simply done an abysmal job of interpreting tax legislation. Obviously, I am not referring to all judges; the craft and skill of some judges has been inspiring, however, generally, judges have not assumed their appropriate role or responsibility in the tax law-making process.
Whether one agrees with the generality of this bald assertion may well be a matter of personal opinion. Certainly we would do well to embrace Brooks’ caveat, since in many cases a critique of particular judicial reasoning will be a thinly disguised attack on the politics which guide the result: in a liberal market economy, pro-liberal legal outcomes will not please everyone. Nevertheless, we can observe a reluctance amongst Australian judges to embrace or articulate economic analysis, even in cases where it may have been appropriate to do so.
When the basis of the litigation is an innovative financial product which has been designed primarily because of its financial attributes, such conservative jurisprudence would appear to miss the point. In reality, we can often observe in cases which appear to avoid economic or financial analysis, an unarticulated and often unformed attempt at contextual reasoning. On either level, this trend can not continue if we are serious about improving the efficiency of our tax system.
It is submitted, with respect, that there should be serious consideration given to the pursuit of the following measures, either alone or in tandem:
1. the introduction of a new, mandatory tax bench at the Federal Court level, staffed only by qualified tax professionals;
2. the requirement that any judge sitting on tax cases participate annually in advanced economic and financial training, including with reference to financial innovation and arbitrage techniques;
3. the introduction of new, voluntary system of mediation, with mediators once again only being drawn from the ranks of qualified tax professionals.
We can observe the incoherence of the current formalist tax approach in cases such as Radilo (Radilo Enterprises v FCT). The decisions of Mr. Justice Davies at first instance and of the three judges in the decision of the Full Federal Court are, with the greatest respect, remarkable because they each reach essentially the right conclusion, despite anachronistic legislation and inadequate attention to financial reality. Since that case dealt with the powerful and corporate life saving synthetic, the converting preference share, this archaic judicial approach can no longer be tolerated.
If we wish to consolidate an approach which includes economic or financial analysis, we must do something more than making it effectively optional, as is the case in sec. 46D which was considered in Radilo. For example, we might consider embedding the concept directly within the operative aspects of the legislation, making it impossible to proceed without a contextual approach (this is the likely procedure under the revised Budget measures, which rely on the "delta" concept). A stronger approach would be to assert the relevance of financial analysis by embedding it within the proposed "Charter of Business Taxation," (see Part II below).
The Tax ReValue approach.
This approach would require judicial and administrative consideration of the basis upon which corporate issuers and investors appraise the financial risks and rewards of capital market transactions, such as those involving equity, debt and synthetic positions. This approach would allow for a realistic contextual evaluation of these structures, and may be termed the "Tax Effected Regulatory Efficiency Valuation" ("Tax ReValue") approach. For example, in the context of the equity and synthetic equity market, the essence of the Tax ReValue approach is that:
If the inclusion of economic analysis of the sort advocated in this submission occurs in relation to tax laws, the benefit should be a more realistic and refined approach to the question of characterisation. If we can rationally consider the extent to which both the legal form and the economic substance of a security tend to display the same characteristics (whether of debt or equity) the tax response should be cleaner and more transparent than under the current approach.
For example, if a synthetic:
the Tax ReValue approach would consider that the synthetic has a sufficient equity like financial profile to support the allocation of the equity tax benefits (in conjunction with the examination of the technical legal form of the synthetic). On this approach, efficiency is enhanced, taxpayer equity is promoted, as between the treatment of the simple and synthetic equity issuer and investor, and consistency is advanced in comparison to the current uncertain tax treatment of synthetics.
In conclusion, the Tax ReValue approach will assist tax administration and taxpayer compliance, and reduce non – linearity. It is of course also acknowledged that the quest for the elusive "global pattern taxation" will require a more systemic reformist approach; and it is in this regard that recommendations for the "Franked Debt" approach to the alignment of debt and equity have been made.
II. SPECIFIC OBSERVATIONS OF THE REVIEW OF BUSINESS TAXATION: "A STRONG FOUNDATION" AS A TEMPLATE FOR THE TAXATION OF RISK.
In the context of the tax policy template for the neutral taxation of risk which was developed in Part I, this submission now addresses specific issues raised for comment by the RBT "A Strong Foundation" paper. These issues are dealt with in the sequence which they are raised in the ASF paper.
A. NATIONAL OBJECTIVES FOR BUSINESS TAX REFORM.
With respect, the RBT has correctly identified the core objective of business tax reform as the pursuit of:
A stable, simple and more coherent business tax system. Such a system will lead to more robust investment decisions, improved competitiveness, greater productivity, higher gross domestic product growth and more jobs.
These sentiments should continue to drive the agenda of the RBT, and should be addressed on two levels. First, the pursuit of tax linearity will improve tax law coherence. Second, the manner in which linearity is achieved should be considered effective, only of it increases the efficiency of the business tax system. This efficiency increase will be observed if the tax system facilitates risk neutrality and financial innovation. Tax efficiency is measured where the tax system does not prevent or distort the transfer of risk issuance or purchase of financial products which lower corporate capital costs and/or enhance investor returns. Accordingly, tax efficiency will be delivered where the restrictive anti-avoidance rules referred to in Part I are removed.
B. ENTITY TAXATION, DIFFERENTIAL TAXATION AND TAX INCOHERENCE.
The ASF paper states that the RBT seeks to minimise "differential taxation of business entities." This is an important aspect of introducing tax linearity, but the "Entity Taxation/Deferred Company Tax" analytical framework which is proposed in ASF is adrift from rational tax policy and international best practice. The clear anti-avoidance perspective expressed in this framework can be accommodated by the imposition of a withholding tax regime applicable to tax preferred distributions to domestic investors. This is the approach recommended by this submission.
The "Entity Taxation" measures proposed in the ASF paper would align the tax treatment of trusts with that of companies, and would impose a new equalisation tax ("Deferred Company Tax") on tax preferred distributions from such entities. The International tax policy perspective is clear: it is inappropriate to seek to align the taxation of trusts with that applying to companies; the corollary is the correct approach. This is recognised by the US, which has conduit taxation rules which allow the pass out of tax benefits to members (ie, Sub-Chapter S Corporations), who are then taxed at their applicable marginal rates. If tax avoidance is perceived to be occurring in Australia through tax free distributions being made to trust beneficiaries, (who then avoid/evade tax at their personal level), the appropriate remedy is the imposition of a refundable withholding tax. In the context of the RBT review of tax preferences, (which will result in tax preferences being retained only to correct "market failure") it is appropriate for the pass out mechanism implicit in conduit taxation to be retained in the case of trusts, as well as extended to the corporate form.
The tax policy basis of entity taxation.
The most eloquent case for the taxation of trusts as companies has recently been made by Professor Rick Krever of Deakin University. Rick moves beyond the simple idea that fairness and equity are the touchstones for the reformist approach, and links the argument to the question of tax preferences:
If the taxpayer personally takes the risk, the taxpayer should be entitled to enjoy the tax benefits available to those who take risks; if the taxpayer shelters behind a limited liability entity such as a company, the tax benefit should only be available to the entity and should be clawed back when passed through to the underlying owner.
Rick aligns the position of a beneficiary of a discretionary trust with that of a risk diminished limited liability shareholder, and suggests this as the basis of the denial of tax benefits to those beneficiaries.
The core problem with this approach is that it ignores the fundamental importance in capitalist economies of risk minimisation, particularly the historical importance of the limited liability corporate form as an engine of economic growth, prosperity and job creation. As the influential thinker, Peter Bernstein, reminds us in his seminal work on risk:
The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than the whim of the gods and that men and women are not passive before nature.
A tax rule which discourages risk taking in collective form will discourage those collective investments, threatening the comparative viability of aggregated capitalism. The focussed reader will immediately notice that limited liability shareholders already suffer the deprivation of certain tax benefits available to individuals and beneficiaries (for example, the "wash – out" of CGT indexation, discussed in more detail below). Were it not for the fact that this deprivation of tax benefits is totally unconnected with the fact of risk minimisation through corporate investment, this point might be fateful, by analogy, for the present defence of trust based investment.
In fact, the real basis upon which this aspect of the attack on trusts is founded expresses a fundamental disdain for the collective investment of capital, in any form. This disdain has been roundly criticised, especially in the context of evaluation of the appropriateness of imputation systems (which "reduce" taxes on corporate income, compared to "classical" double tax systems). Imputation systems recognise that individuals investing in income producing activity pay one layer of tax on their profits; without imputation (or similar systems) the same activity will produce double tax if the investment is made through a corporate entity. Critics of imputation systems generally propose four reasons in favour of corporate double tax, and these are the logical springboard for the welfarist attack on trusts:
Unfortunately for the advocates of the taxation of trusts as companies (which rely on these types of arguments to support their case), these propositions have been targetted by the leading global expert on imputation systems as totally "unconvincing." Professor Alvin Warren of the Harvard Law School has succinctly stated in response to these propositions that:
…the separate legal status of corporations is not today a compelling rationale for a separate and substantially distortionary tax on corporate income…Nor do the benefits of incorporation suggest that corporations should be taxed in addition to (their) investors…
By analogy, these comments apply just as clearly to trusts. In fact, despite the "privilege of incorporation" argument for double taxation of corporate income (and by extension, trust income), Parliamentary sanction for the corporate form actually responded to the concerns of creditors faced with debt recovery from the early business vehicles, typically extended partnerships. Granting separate legal status to the corporate form removed the need for creditors to serve process on, and individually sue and recover debts from, each individual partner. The "benefits of incorporation" argument for high corporate taxation is one of the great tax furphies of the modern tax world.
In conclusion, attacking trusts because they offer similar risk reduction outcomes to corporate investment is unfounded in logic or policy, and the approach can only be understood when it is seen as the proxy for the denial of the range of deductions and tax expenses currently available directly to investors in trusts.
If conduit taxation is not to be extended to companies, then the approach to tax preferences should be:
1. domestic tax preferences should be stacked such that they are not exposed to Deferred Company Tax;
2. foreign source income should be available for distribution without the imposition of DCT.
C. THE COMPREHENSIVE INCOME TAX BASE.
One of the critical issues for contemporary business taxation is the choice of tax base. Tax may be levied on any form of economic activity, but the choice of tax base should ensure that the tax collection mechanism maximises taxpayer equity and economic efficiency. Three possible tax bases are mentioned in the ASF paper, ie "comprehensive income taxation," "cash flow taxation," and "schedular income taxation," and these are briefly dealt with below. This submission endorses the near term perspective expressed in the ASF paper, that:
As part of the overall design of a new tax base, the treatment of depreciable assets now in place, the taxation of financial arrangements, transitional provisions and international taxation implications would all need consideration. With these considerations and its reporting timeframe in mind, the Review has interpreted its terms of reference as confining its attention to an income tax base as the relevant operating principle.
However, the International tax policy perspective is clear: if the Australian business tax system is to be equitable and efficient in the long term, we can not avoid the move to an expenditure or cash flow base for business and personal taxation. Cash flow taxation offers the best possibility for removing the need for a characterisation based approach to tax collection. It does not need to distinguish between transactions on income or capital account, and does not question whether (and when) a cash flow is deductible or assessable (cf the current approach to the question of interest deductibility). Csh flow taxation should be a priority item for investigation as part of ongoing tax policy formation after the RBT reports.
The inexorable benefits of cash flow taxation.
Expenditure or cash flow taxation is widely accepted as an ideal tax policy basis for measuring and collecting revenue, because it optimises both taxpayer equity and economic efficiency:
Cash flow taxation…would exempt some capital income in the sense that there would be no difference between the pre-tax and after-tax rates of return on that capital…there is wide agreement on this proposition amongst tax policy analysts…like an income tax, a cash flow tax would include receipts from a variety of sources, including receipts from capital investments. The key distinction between the two taxes is that capital costs are currently deducted (or "expensed") under the cash flow tax, whereas they are capitalized and later deducted (as depreciation or basis) under the income tax.
The cash flow tax exempts the profits of capital from taxation until they are expended in consumption. Cash flow taxation optimises taxpayer equity, measured in terms of distributive fairness:
The case for the (cash flow) tax base as a matter of distributive fairness is that society’s interest in a just distribution of economic resources goes to standards of living rather than to social product…Specifying the social claim on private resources as a claim on consumed resources rather than (as a claim) on social product, as under an income tax, is justified on the view that the ultimate goal of productive activity is human consumption, so that unconsumed product is simply not relevant to a distributional calculus…Under a consumption tax, a citizen’s moral claim is for a fair share…of the goods and services consumed during the accounting period. Under an income tax, it is for a fair share of the goods and services produced during a period.
Cash flow tax also offers the possibility of resolving some key obstacles to optimal economic efficiency, particularly by removing current distortions in the taxation of savings and corporate taxation, and the taxation of capital in the international context. Concerning savings, an income tax involves double taxation, since the profit from labour or income is subject to tax, and then upon the investment and earning of profit on that first amount, another layer of tax is levied. This point has been recognised since the time of John Stuart Mill, who noted that:
"…unless savings are exempted from income tax, the contributors are twice taxed on what they save and only once on what they spend.
Apart from removing the double taxation of savings which exists under an income tax, a cash flow tax delivers domestic and International efficiency benefits. The domestic benefits are clustered around the removal of the characterisation basis of taxation; and the International benefits are related to the removal of double taxation on capital which is involved in the income tax system:
…International double taxation will arise when both the source country and the country to which the goods, capital, profits or earnings flow-the "residence" country-decide to tax that flow and the residence country does not give full credit against its tax for the source country tax.
Speaking of a cash flow tax system in the International context, it has been said that:
…a country concerned to attract inward investment and to lower the cost of capital to its domestic enterprises, will have an incentive in open capital markets to reduce the tax charged on capital incoem and move towards an expenditure tax treatment.
This logic is compelling in the current context.
Tax Preferences Or Proper Deductions - What Is A Tax On "Income"?
If the RBT is unable to consider an expenditure or cash flow tax basis for business income, it is appropriate to re-appraise the basis upon which the income tax is levied. Combined with the radical attack proposed by "Entity Taxation" on risk minimisation through trusts and companies, we can also observe in it a more fundamental disdain, for the idea that an income tax base is fair and appropriate. This is because the new approach will effectively quarantine the benefits of interest deductions which are currently directly available to trusts beneficiaries pursuant to Div. 6 of the Tax Act.
The formulation of income as the appropriate tax base was well under way by the time of Adam Smith; and the essential formulation of the concept of the income tax as a tax on net accretions to wealth was famously laid out by Haig and Simons at the turn of the 20th century. The idea of a tax on net gain is part of the capitalist approach to social organisation, since it recognises that investment for growth will involve expense. The large part of that expense is the compensation to the capital provider for depriving it of its money; not only does this involve an opportunity cost to the investor, it imposes upon it risk.
Taxation of gross cash flows without deduction for costs and losses ignores the reality that investment capital is not free, and that investment decisions involve risk. The concept that we should impose tax on net income is thus fundamental to the organisation of capitalist economies, and underpins the modern corporate finance analysis of risk and investment, at least since the pioneering work of Modigliani and Miller in the late 1950’s and early 1960’s.
The attack on trusts is really a proxy for an attack on the concept of income as the tax base: it is code for the proposition that capital costs and income losses should no longer be recognised as legitimate expenses for tax purposes. Krever again:
By the time of the mid – 1980’s (tax) reforms, the Australian business and investment base had been badly eroded by numerous intended concessions (such as accelerated depreciation, concessional allowances, and excessive research and development and Australian film write – offs) and unintended loopholes that had been retained, or at least tolerated, as subsidies for desirable investment (for example, negative gearing to increase the stock of rental accommodation and to encourage investment in the stock market).
Krever points out that the Australian imputation system effectively "washes out" these tax benefits: since the tax benefits reduce corporate tax payments dividends may be less than fully franked, imposing tax on the shareholder on distribution of corporate profits. Not only is Krever unconcerned by the wash out effect, he argues for the extension of it to trusts by the imposition upon them of a tax regime, as if they were companies. Since the "tax trusts as companies" theme is really about denial of certain tax benefits, let us analyse those tax benefits against the tax policy criteria of equity and efficiency.
Deductions are equitable and efficient.
While it is often hard to support clear tax expenditures like accelerated depreciation and film deductions, Krever’s other category of "unintended loopholes" are really no more than the proper recognition by our income tax system, that income producing expenses are to be netted off from gross cash flows to determine taxable gain. Despite the comments to the contrary from populist writers like Brian Toohey, far from being tax subsidies, the deduction of the interest expense for property and share investment targetted by Krever is well recognised in the literature as being consistent with the income tax base. Consider the acknowledgement of this point by the Australian Treasury (and also note the Treasury disdain for the welfare proposal for the quarantining of negative gearing expenses, against similarly sourced income):
On conceptual grounds, expenses incurred in earning assessable income should be deducted from that income in determining taxable income…legislation that "attached" certain debt to certain income would require tracing rules that could be avoided by all but the uninformed or imprudent…
Similar points have been made by the Yale Law School Professor Michael Greatz in his testimony to the US Congress hearings on debt funded takeovers:
…experience suggests great caution in attempting to enact solutions that…attempt a disallowance of interest to indebtedness incurred for a particular purpose…The past two decades also teach that there is little gain and no stability to be had from such marginal tinkering…
Finally, let us look briefly at the most confident and creative recent attempt to limit the tax deductibilty of interest expenses, which ironically was proposed by Alvin Warren in 1974. Warren’s proposal was fundamentally driven by his recognition that debt and equity are functionally equivalent, and should ideally be taxed the same (which explains my proposal for a system of "Franked Debt"). Although well founded, Warren’s logic initially produced the strange proposition that interest payments should be included (ie not excluded, by the tax deduction) from the corporate income:
…there is no conceptual mandate for excluding interest payments from the corporate tax base.
This proposition was subsequently withdrawn by Warren, in his famous 1981 piece on imputation. His retraction echoes my earlier comments about the importance of accounting for losses (produced by risk) and capital cost in determining the taxable or net income:
If the corporate tax reached all corporate income, it would distort corporate investment decisions because the return subjected to tax would not be reduced by the cost of capital. For example, a 12 per cent annual return financed by borrowing at 10 per cent would produce a 2 per cent profit before taxes, but a 4 per cent loss after taxes if the corporate tax rate were 50 per cent and interest non – deductible. For this reason, I now think that (the earlier position), that corporate interest payments be made nondeductible is inappropriate.
The RBT must confirm that, so long as we have an income tax system, legitimate deductions (including in respect of the cost of debt capital), should continue to be fully deductible, and directly available to trust beneficiaries.
It is also noted that the comprehensive income tax base requires, if an accruals or market value tax accounting regime is adopted, that a full loss carry back/carry forward regime be available to taxpayers:
A "snapshot" of the value of an asset, even if valued by reference to the amount it would realise at that time, may be no guide to the value at another time, given that no actual realisation takes place. Comprehensive income taxation involves aggregating asset values but may also require carry-forward and carry back loss reliefs to ensure that comprehensive income is correctly taxed over time.
D. TAX POLICY AND ADMINISTRATION.
Some brief comments concerning the role of the ATO in tax policy formation and administration are appropriate. The ATO continues to perform a vital role with (on the whole) a professional and rigorous approach to its task. The ATO should be better funded and equipped in future to perform this role. The opportunity for the ATO to move to a user pays approach, including by the introduction of a system of user charges for the provision of rulings, should be explored by the RBT.
In saying this, it is clear that the current system where the ATO performs the dual roles of statutory interpretation and revenue collection involves an unsustainable conflict of interest. The revenue collection function should be separated from the technical legal interpretative function, as a matter of priority.
In conjunction with this separation of roles, the ATO tax policy formation task should be more systematically combined with (within?) the functions of the Commonwealth Treasury. The tax policy formation analysis expressed in the ASF is endorsed. Early identification of issues is necessary for an efficient business tax system, and as part of this approach, it must be clearly specified within the Charter of Business Taxation that:
1. there should never be retrospective tax laws, nor should legislation by Press Release continue;
2. tax policy should be formed by analysing the efficiency of existing and proposed new tax laws;
3. economic analysis, for example along the lines of the Tax ReValue approach, should be mandatory as part of tax policy formation;
4. if a Business Advisory Board is constituted for the ATO, it must be supported by the resources of a full time and properly constituted Secretariat, and both the ATO Board and Secretariat should be populated by demonstrably skilled and eminent tax professionals, who are currently practicing as such;
5. the ATO Board should include specific representation in respect of the risk management and innovative financial product market, and the appraisal of tax policy issues in this area should be enshrined as a core element of the Charter of Business Taxation.