Submission No. 45 Back to full list of submissions
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Comments on the Review of Business Taxation’s Discussion Paper

A Strong Foundation – Establishing Objectives, Principles and Processes

31 December 1998

Executive Summary

Accepting the broad objectives of economic growth, equity and simplicity, IBSA has a number of comments on the Policy Design Principles and taxation processes proposed by the Review of Business Taxation in its paper A Strong Foundation.

The Tax Treatment of Risk

The tax treatment of risk should be rigorously considered by the Review, as several recent tax policy initiatives have exposed an inconsistent and misguided policy approach to risk. The Review should then provide guidance for the taxation of risk in its policy design principles. This would improve the clarity and consistency tax policy and prevent some past mistakes from being repeated.

Risk generates a reward that stays with it if it is transferred. Drawing on this, the Review should state that, in general, transactions involving the transfer of risk can be safely ignored from a taxation perspective, as risk management does not autonomously involve a threat to the tax revenue base. There are limited exceptions that may require special attention – but they should not drive policy.

A subsidiary objective that should be adopted in the policy design principles is that tax measures should encourage efficient management of risk, as this would benefit the economy through a variety of mechanisms.

Tax Compliance Costs

Excessive tax compliance costs are a dead-weight loss to the economy. A clause should be included in the principles to the effect that compliance costs should not exceed a given proportion of the associated tax revenue.

The Commissioner of Taxation should be given a limited discretion to set-aside tax provisions where the cost of complying with those provisions is excessive.

International Competitiveness

The Review correctly cites the need for the tax system to be internationally competitive, but this should be given greater emphasis. The proposed entity tax regime has serious deficiencies when measured against this benchmark, which the Association will address in a later submission.

The authorities need to take a pragmatic approach to benchmarking and give due weight to international competitor regimes when assessing issues like tax neutrality. For example, the benchmark tax rate for offshore banking units is that which prevails in competing regimes offshore, not the domestic corporate tax rate.

The Government should continue to support efforts to achieve greater consistency across jurisdictions on tax key matters; for example, through ATO participation in OECD working groups.

‘Catch All and Consult’ Approach to Tax Change is Wrong

Some tax changes have been developed by casting a wide net, for example through a Government announcement, and then reducing the catch through industry consultation. This ‘catch all and consult’ approach to tax policy development and implementation is misguided and particularly harmful for financial markets. The Review should recommend that this approach be halted and that instead, reliance be placed on its proposed integrated business tax design process, as it would better focus new taxation measures.

Reforming Business Tax Processes

IBSA supports the approach taken by the Review in its proposals to improve the ATO’s structure and operations.

The Government should provide a clear operating charter to the ATO that extends beyond the uninhibited collection of tax and requires it to have regard to economic development, employment and international competitiveness in its operations.

Effective industry consultation at a technical level is important too. The Review’s proposed business tax design process would be of assistance here.

New policy initiatives should be formally assessed against the Review’s design principles and departures from them identified and justified. It is important that consistency across policy area is maintained, which has not always been the case.

An ATO Advisory Board – A Positive Step

The Review’s proposal to establish an ATO Advisory Board would be a positive contribution to the development of a better dialogue between the tax authorities and industry. The Board should include ATO and Treasury representation but have a substantial majority of members from the private sector.

Taxation Rulings

It is unfair to charge taxpayers for tax rulings, since under a self-assessment regime, they should be able to rely on the law for reasonable clarity and certainty.

The plan to provide public information on private rulings, by way of a database on decisions would be a positive development.

A More Responsive Tax System

In some areas, like offshore banking, greater tax flexibility through the use of regulation within a well-defined policy set by Parliament would improve the international competitiveness and efficiency of the tax system.

Part 1

Comments on the Framework in A Strong Foundation

This part of the submission addresses the framework for taxation proposed in the Review’s first paper, A Strong Foundation - Establishing Objectives, Principles and Processes (ASF). The second part of the submission considers the tax treatment of risk in detail.

1. Policy Design Principles of Taxation

The identification of economic growth as a key national objective for the taxation system in ASF is correct. This is the primary objective that encompasses other objectives, notably those of creating employment, maintaining an internationally competitive environment, generating savings and investing capital efficiently. Each of these objectives is important and they are interrelated.

The other national objectives, equity and simplification, are also important. Simplification, especially clarity in tax law driven off well-defined principles, is vital to the achievement lower compliance costs – a key objective of tax reform.

Accepting these broad objectives, there are several points that IBSA would like to make in respect of the Policy Design Principles set out by the Review.

1.1 The Tax Treatment of Risk

The Review should address the tax treatment of risk in more detail than it does in ASF. Tax policy is being increasingly based on risk concepts (variously defined), as evidenced in the 1997 Budget franking credit measures, amongst other things. Because the tax treatment of risk has not been subject to a systematic and conclusive review, there are inconsistencies in the concept of risk employed in different measures and several recent policy initiatives have been misguided and harmful to the financial sector and the wider economy.

To help overcome these problems, the Review’s policy design principles for taxation should specifically address the tax treatment of risk. In general, transactions involving the transfer of risk can be safely ignored from a taxation perspective, as risk management does not autonomously involve a threat to the tax revenue base. There are limited exceptions involving tax-exempt entities and non-residents that may require special attention – but they should be treated as exceptions and not drive policy.

Effective risk management supports the smooth operation of the economy and the trading and management of risk is a central feature of the services provided by the financial sector. Therefore, it is vital for the long-term welfare of the economy that the tax treatment of risk is well defined, consistent, efficient and properly reflective of the underlying economics of the transaction. These issues are discussed in more detail in Part 2 of this submission.

1.2 Compliance Cost

The principles for policy design should explicitly address the need for tax compliance costs to be minimised, since elimination of excessive compliance costs, which are a dead-weight loss to the economy, is a key objective of tax reform. It could be argued that this sentiment is implicit in the proposed principles, but it would serve the community well to have it clarified beyond doubt.

To this end, the principles should contain a clause to the effect that compliance costs should not exceed a given proportion of the associated tax revenue income (including revenue protected by the measure). The Treasurer should set the actual threshold test criteria after consultation with the ATO and industry on the issue. If compliance costs with a particular tax stream were found to be excessive and the test failed, then that stream of revenue should not be collected and more efficient tax alternatives sought. In effect, adoption of this clause would be a means to help ensure that the efficiency of the tax system is secured on an ongoing basis.

IBSA has dealt with cases where members’ cost of complying with a tax measure came close to or exceeded the tax revenue collected. Clearly, this is in no one’s interest – it undermines the integrity of the tax system and unfairly penalises affected taxpayers. From our experience, there would be a significant advantage in providing the Commissioner of Taxation with discretion to set-aside tax provisions where the cost of complying with them is excessive. As a control mechanism, a limit could be placed on the quantum of aggregate revenue that can be foregone in each case – though it is likely that the Commissioner would err on the side of caution in any event. This would not be at variance with the operation of current tax law, as the Commissioner already has a wide degree of discretion.

1.3 International Competitiveness

The economy has developed to the point where a large number of companies participate in international markets, or in markets that are contestable by foreign companies. In addition, Australia must compete with other countries for internationally mobile capital, the volume of which has increased markedly in recent decades. These trends seem likely to accelerate rather than dampen over the medium term, notwithstanding the region’s ongoing financial crisis.

The tax system has a significant bearing on the competitiveness of the economy from the point of view of foreign entities investing in Australia or placing their production units in Australia. Therefore, the Review is correct in citing the need for the tax system to be internationally competitive as an important principle to guide the design of tax policy. In this regard, the proposed entity tax regime should be measured against a benchmark that attaches a high weight to the improvement of Australia’s international tax competitiveness. IBSA has serious concerns about the entity tax regime which, as proposed, would weaken international competitiveness. These issues have already been raised by other bodies, like the Australian Stock Exchange, and will be taken up by the Association in more detail in a later submission.

The formulation of tax policy typically involves conflict at some levels between the Government’s tax objectives. For example, in the recent past, the authorities have considered it necessary to adopt tax measures that discriminate against foreign owned companies, in order to protect the tax revenue base. Decisions of this nature should be subject to greater scrutiny and accountability from a policy perspective and the Review’s policy design principles should be helpful in achieving this.

In general, new policy initiatives should be formally assessed against the design principles and departures from them identified and justified. This would be a practical way of helping to clarify the policy development process and improve accountability within that process.

Overseas tax regimes provide a benchmark against which the international competitiveness of Australia’s tax system should be judged. For example, a 10% offshore banking unit (OBU) tax regime may seem concessionary against a domestic corporate tax rate of 36%, but it is hardly so when viewed against a similar tax rate for offshore banking in competing jurisdictions, like Singapore, especially as the overall tax package there is superior. If the OBU tax rate were set at the normal corporate tax rate, then Australia would not attract offshore banking business.

Thus, the authorities need to maintain a pragmatic approach to benchmarking when assessing issues like neutrality in the ongoing development of tax policy. Also, the costing of tax measures should take account of both the direct and indirect tax revenue benefits.

Companies with significant foreign source income and foreign shareholders must deal with tax regimes that differ between the jurisdictions in which they operate. Ultimately, their income stream may be assessed for tax purposes in two or more countries and there is significant risk of double taxation. Since many of the tax problems arising from international capital flows related to inconsistent approaches to revenue sharing, this matter can only be resolved efficiently within a multilateral framework. Therefore, the Association encourages the Government to continue supporting efforts to achieve greater consistency across jurisdictions on key matters. Participation by the ATO in international forums that address these issues, like the OECD, is a positive contribution that should be supported.


2. Reforming Business Tax Processes

Efficient implementation of tax law is just as important as a good tax structure to a good tax system. The situation in Australia can be improved and IBSA supports the approach taken by the Review in its proposals to improve the ATO’s structure and operations. Ultimately, the objective should be to enhance the sensitivity of tax policy to the economy’s development needs.

There is a need to foster a culture within the tax authorities that is better focused towards the wider economic implications of tax measures and the economy’s development. In particular, the ‘big picture’ should be kept in sight when implementing tax policy and there should be a natural bias in favour of removing tax impediments to the efficient operation of the economy. The Government should provide a clear operating charter to the ATO that extends beyond the uninhibited collection of tax and requires it to have regard to economic growth, employment and international competitiveness in its operations.

There can often be a conflict between the Government’s need to raise tax revenue and its desire to promote economic development through efficient and fair taxation. The Government must strike a clear balance between the two objectives. Otherwise, the ATO’s task of administering and interpreting the law would be very difficult. In addition, industry would face continued inconsistency across policy areas that, for example, have been harmful to efforts to develop Australia as a regional financial centre.

2.1 ‘Catch All and Consult’ Approach to Tax Policy is Wrong

On several occasions in the recent past, tax policy change has been developed and implemented by initially ‘casting a wide net’, usually by way of a Government announcement or draft legislation, and then refining the catch through a consultation process with industry. The 1997 Budget franking credit measures is an example of this approach and, indeed, the entity taxation proposal in A New Tax System contains an element of this too. In some instances, this ‘catch all and consult’ has been a deliberate strategy by the authorities, which is misguided, as it is particularly harmful for financial markets when they are affected by measures.

There is no doubt that significant improvement to tax policy and legislation emerges from consultations with industry. However, the intervening uncertainty inhibits investors, especially non-resident investors, and can cause long-term damage to the affected markets. Some residual harm persists, even if the right solution is found at the end of the process.

Leaving aside the problem of uncertainty, the ‘catch all and consult’ approach is still sub-optimal because, under it, industry has to participate in consultations under the threat of penal provisions and under these conditions the compromise achieved is not a fair balance. The Review should recommend that this approach be halted and that instead, reliance be placed on its proposed integrated business tax design process, as it would better focus new taxation measures.

2.2 An ATO Advisory Board – A Positive Step

IBSA supports the Review’s proposal to establish an ATO advisory board, which would help establish a better dialogue between the tax authorities and industry. Consequently, IBSA welcomes this proposal. In our experience, there is a strong need for an advisory board and preferably one that is pro-active in responding to policy developments. The Board should include ATO and Treasury representation but have a clear majority of members from the private sector.

The self-assessment regime places an obligation on the ATO to provide taxpayers with clear guidance on tax provisions, so that they can reliably determine and pay their tax liability. Self-assessment should not be a gamble for taxpayers, but in some instances it has been and remains so. To overcome this problem, the ATO will need to develop good commercial acumen and respond quickly and flexibly to queries and new developments. Guidance from an effective advisory board would be of assistance to the ATO in its effort to respond in this manner.

The ATO may require additional resources to fulfil its obligations in a more commercially sensitive manner, since this requires individuals with specialist skills (apart from tax). The Advisory Board could play a useful role in the vetting process for the release of funds to support the ATO’s operations. However, the Board’s advice should not form part of normal management audits.

Technology and globalisation of markets will have an ongoing impact on taxpayers and, consequently, the tax base. An important objective of tax reform should be the creation of mechanisms for ongoing review of the tax system by the tax authorities, so that it is adapted flexibly to changing policy and environmental conditions. Effective industry consultation is a vital ingredient to their success in this and the Advisory Board could contribute usefully in this regard. This would help ensure that the tax system operates in a commercially sensitive manner and continually evolves to better meet the Government’s policy objectives.

It is the Association’s experience that effective industry consultation at the implementation level can assist the design and efficient implementation of tax measures. The business tax design process suggested by the Review would make a welcome contribution in this regard. This could improve coordination between Treasury and the ATO, which would help avoid practical difficulties that industry has encountered in the past.

2.3 Taxation Rulings

Public, private or product tax rulings fill a deficiency in the tax law that creates uncertainty, or reflects a gap in the material available to taxpayers to help them correctly interpret the tax law. This is not necessarily a criticism of policy makers or law drafters, as innovations that occur after legislation is drafted and passed by Parliament can create uncertainty that needs to be addressed by a tax ruling.

Nevertheless, it would be unfair to charge taxpayers for tax rulings under a self-assessment regime, as they should reasonably be able to rely on the law for clear guidance in the determination of their obligations. In addition to this, taxpayers must already meet substantial compliance costs. When a question of interpretation of the tax law arises, it should be incumbent on the Commissioner of Taxation to state his view to enable taxpayers to meet their tax obligations.

Therefore, in principle, the Association would not agree with a proposal to charge fees for tax rulings provided by the ATO. Indeed, the notion of linking the charge for rulings to their commercial value is unusual, especially since some would have a negative value to those requesting it. Greater detail would need to be given on the manner in which the charge would be levied and information on the consequent ruling made public, since the payer could reasonably expect to have a propriety claim on a ruling that it paid for.

Notwithstanding this argument, many banks take the pragmatic view that charges for rulings would be preferable to the cost of unnecessary delays in the issue of rulings. In reality, this is a preference for the lesser of two evils.

The plan to provide public information on private rulings, by way of a database on decisions would be a positive development.

3. A More Responsive Tax System

A significant impediment to the ongoing efficient taxation of financial institutions and the maintenance of the international competitiveness of the financial sector is the slow process of achieving even modest refinement to the tax arrangements. This occurs even if there is consensus between Government and the industry on the need for the change. This substantially emanates from the requirement for legislative amendment to back-up most tax changes and this process can take well over a year.

For example, the Government’s December 1997 Investing for Growth regional financial centre initiatives were well timed but have yet to be legislated for. This outcome is frustrating as the advantage of good timing is being lost and financial institutions cannot avail themselves of the opportunities that the measures create. There would be great benefit in avoiding such problems by improving tax flexibility and efficiency through the use of regulation in some areas, such as offshore banking, within a well-defined policy set by Parliament. In some areas, like offshore banking, greater tax flexibility through the use of regulation within a well-defined policy set by Parliament would improve the international competitiveness and efficiency of the tax system.

An agile tax system would be a significant competitive advantage to Australia as a regional financial centre. The Government could respond swiftly and flexibly to developments that create new regional financial centre business opportunities and to developments that threaten to take existing business (either OBU or domestic banking business) conducted.


Part 2

The Tax Treatment of Risk

1. Introduction

The tax treatment of risk is a major concern for financial institutions, as their primary business involves the management, trading and transfer of risk. However, the Review of Business Tax’s first discussion paper, A Strong Foundation (ASF), does not comprehensively deal with this issue. It refers to the need for a ‘risk neutral’ outcome to tax but does not attempt to define risk, nor to does it establish any principles to guide the treatment of risk in tax policy or within the general body of tax law.

Yet, the tax treatment of risk has been a very contentious issue for the finance industry. For example, as discussed below, the much-criticised 1997 Budget measures to prevent trading in franking credits is in practice a tax on the management of equity investment risk. There are other examples too and the indications are the problem will to worsen if the underlying policy deficiency is not addressed through the tax reform process.

Unless guidance for the tax treatment of risk is given by the Review, a key building block for the design of an efficient tax system will be missing, the Review’s recommendations will be flawed and the community is likely to suffer further from inefficient and harmful tax law.

Even if wholesale reform of business taxation were not contemplated, the tax treatment of risk would need to be considered, as there is not a settled policy on the taxation of risk at present. Against this backdrop, the Review provides a timely and fortuitous opportunity to establish firm guiding principles for the taxation of transactions and arrangements that involve risk.

The key principle is that, in general, transactions involving the transfer of risk can be safely ignored from a taxation perspective, as risk management does not autonomously involve a threat to the tax revenue base.

There are exceptions to this rule, but they should be treated as such and not drive the core policy treatment of risk, as they appear to do at present.

A design objective of the tax system should be to encourage efficient risk transfer and management, because it is beneficial to the economy.

The following sections of the submission illustrate these points and outline the need for a rigorous and systematic high level policy review of the tax treatment of risk. They also provide some analysis to help understand the nature of risk, in its many forms and provide some insights into the practical difficulty of trying to use it as a concept in taxation. Most importantly, they provide some basic principles that should be reflected in the formulation of tax policy and the administration of tax law, that overcome this problem.

2. The Problem

It is apparent from a number of recent tax policy decisions that the taxation of risk, or products and transactions involving risk transformation, is not based on a sound or consistent policy footing. This is evident from the rationale provided for recent changes to tax policy and the manner in which it has been implemented. Two examples are provided below to illustrate this.


Example 1. Division 243 of Lapsed Taxation Laws Amendment Bill (No. 4) 1998

The absence of policy principles to guide the tax treatment of risk has led to the adoption of a measure of risk exposure in Government proposals to claw back depreciation in certain circumstances that make no economic or commercial sense and give rise to anomalous and harmful results.

The original Taxation Laws Amendment Bill (No. 4) 1998 (TLAB 4) included provisions that claw back depreciation already claimed in respect of limited recourse finance arrangements that are deemed to be terminated. The Bill has lapsed but these provisions are still under active consideration by the Government. Industry argues that the provisions are based on faulty policy and will be harmful to both banks and their customers. Leaving aside the core policy issue of the validity of the depreciation claw back, it is instructive for current purposes to focus on the policy treatment of risk in the provisions.

Box 1 Example – Approaches to Risk

Company purchases an asset at costing of $1,000

Financed by $200 Equity & $800 Limited Recourse Debt (LRD)

Equity rate of return 14%

LRD interest rate 7%

Risk-free debt rate 5%

Division 243 Approach Þ Equity risk exposure is 20%

Equity risk = 200/1,000 = 20%

Economic Approach Þ Equity risk exposure is 53%

Equity risk component = Equity funding% x Risk premium (14%-5%)

  • = 20% x 9% = 1.8

Debt risk component = Debt funding% x Risk premium (7%-5%)

  • = 80% x 2% = 1.6


In broad terms, the right to depreciation deductions under limited recourse finance arrangements (as defined) is dependent on the proportion of risk carried by the borrower. For example, if an asset costs $1,000 and is financed by $200 equity and $800 limited recourse debt, then the borrower can claim depreciation up to 20% of the asset cost at termination of the loan (as defined).

As illustrated in the example in Box 1, the approach to risk taken in Division 243 provides an outcome that is radically different to that dictated by economic criteria; in fact, it underestimates equity risk exposure by a factor of over 2.5. This is because it ignores the manner in which risk is priced by the market and does not recognise the subtle way in which risk (and its reward) is transferred between the borrower and the investor.

The example in Box 1 is simplified but it serves to make a quite fundamental point. In practice, the definition and measurement of risk is quite complex, as discussed below.

If an accurate assessment of risk were made and the borrower proportionately denied depreciation, then the lender (who shares in the risk of the project) should then be entitled to an equivalent depreciation deduction in respect of the asset. That is, if the lender is deemed under the provisions to take the bulk of the asset risk, then fairness suggests that the lender should be entitled to the full income associated with that risk, which includes the bulk of the depreciation allowance. The provisions do not provide this entitlement, thus creating something of a tax black hole for risk.

However, the most relevant point here is that the concept of risk adopted in the provisions relating to Division 243 is not meaningful from a commercial or economic perspective. Notwithstanding this difficulty, it has been used to help justify a policy approach that, if adopted in legislation as is proposed, would give rise to an illogical and harmful economic outcome. It would penalise many normal financing arrangements and create significant inefficiencies in the allocation of capital. It would also be iniquitous by disadvantaging certain types of borrowers and loan arrangements. In sum, the provisions would be harmful to banks, borrowers and the wider economy.

There are other important deficiencies in the proposed definitions of limited recourse finance and termination, but it is not necessary to consider them for the purpose at hand. The main point to take away from this is that adoption of a set of decent principles to guide the tax treatment of risk would have prevented the development of the proposal and the market would not now be suffering its effects through delays in new financing and refinancing transactions.

Example 2. 1997 Budget Measures to Prevent Trading in Franking Credits

There is great need for solid policy principles to guide the tax treatment of risk. The problems caused by the 1997 Budget franking credit measures demonstrate that, in the absence of such principles, tax law can be poorly focused resulting in serious inefficiencies, inequity and double taxation.

The measures to curtail trading in franking credits announced in the 1997 Budget were intended to combat tax avoidance. In some instances, equity swaps and other products were being used to transfer franking credits from investors who had limited use for them (especially non-resident investors) to investors who could fully utilise them. The Budget measures were targeted at these arrangements and it was generally accepted that some action was necessary, having regard to fiscal constraints. However, there was (and is) great unease in industry at by-products from the manner in which tax avoidance was attacked.

In practice, the measures had a much wider impact than halting trading in franking credits and affected a wide range of transactions that clearly had nothing to do with tax avoidance. For example, under the measures, an investor who opens a futures contract position could lose the benefit of franking credits on recently purchased shares, even though there is clearly no transfer of tax benefits or tax avoidance of any nature in the underlying transaction.

There are two possible explanations for the wider than anticipated impact of the measures. The first is poor policy design, reflecting a failure to understand risk and to appreciate the economic benefits from risk management. However, those with a more sceptical eye view the Budget measures as a ruse to introduce a new policy. The probable answer is that the measures contain elements of both.

Some hold the view that a new policy was introduced, which linked the right to receive franking credits to economic ownership of the underlying shares. Leaving this matter to one side (though it is relevant to the Review’s analysis of tax policy formulation), the analysis here focuses on significant deficiencies in the treatment of risk that emerged through the measures.

Perhaps the main problem with the Budget franking credit measures, as evidenced in their design and discussed below, was the failure to define risk and understand it. This wrong-footed the legislative approach to curtail trading in franking credits and gave rise to an unnecessarily harmful and inefficient outcome.

  1. Failure to understand the economic character of risk
  2. There was insufficient consideration given to the attributes of risk. For example, there was no explicit or implicit recognition of the fact that when risk is transferred the income associated with it transfers to the new risk-holder. Consequently, when the authorities designed the measures and drafted the legislation to implement them, they failed to build on the fact that risk transfer does not generally reduce the aggregate tax base.

    This fact could have been utilised to markedly improve the focus and efficiency of the measures. Because it was not, financial transactions that alter the market risk profile of an investor’s share investment portfolio, but have nothing to do with tax avoidance, may result in the loss of franking credits.

  3. Failure to define risk
  4. The measures are designed around a concept of ‘economic ownership’ that is not defined, but in application is tied to a share investor’s exposure to market risk, measured by a ‘material diminution of risk’ test. Thus, economic ownership relies on the concept of at-risk, which is approximated by a delta type measure. Amongst other things, this lack of transparency made it difficult to conduct a much needed structured policy debate.

  5. Policy not based on principles
  6. The policy was formulated by building upward from tax avoidance to derive policy principles, rather than using policy principles to ascertain and closeout tax avoidance. For example, the concept of at-risk and its measurement were only developed during the course of consultations that followed the Budget. The failure to define economic ownership and risk at the outset gave the impression that the authorities were making it up as they went along and this resulted in poorly targeted measures.

  7. Narrow focus on risk

Analysis of the concept of ‘at risk’ in the measures is limited to market risk only; that is, the risk generated by changes in the price of the relevant share or instrument. Many other dimensions of risk associated with share investment strategies (like counterparty risk, hedge failure risk, settlement risk and corporate control risks) were not considered. This means that the information set from which the existence of tax avoidance is to be assessed is incomplete.

Problems that emerged from the approach adopted in the legislation include:

  • In terms of the Review’s legislative design principles, policy transparency was weak;
  • An incorrect nexus between risk management and tax avoidance;
  • Double taxation in some instances (see appendix 1);
  • A penalty on some legitimate risk management strategies;
  • Complexity and inequity; and
  • High compliance costs.

These problems would not have occurred if the economic and commercial factors governing risk had been understood and principles based on them used to guide the development of policy and legislation. To limit this problem in the future, the Review should recommend adoption of the principles presented in Section 3 below. Their adoption would also help the Review to formulate the proposals to be put forward in its third discussion paper that deals with entity taxation.

In summary, the authorities identified a tax avoidance problem but did not have a sufficient understanding of risk to address it without impeding other aspects of the market, or were unconcerned about the market implications of their measures. As a result, the Budget measures attack risk management per se, rather than specifically attacking the use of risk management instruments to avoid tax, which is a much narrower target. The experience with the Budget franking credit measures suggests that the authorities should focus more on risk management as a legitimate activity that is an integral part of a modern economy and vital to its international competitiveness. The Review can make a positive contribution by helping to create this focus.

2.1 Pending Future Problems

Looking towards the future, deficiencies in the current tax treatment of risk are likely to become even more problematic, if they are not corrected now. The Review presents a unique opportunity to do this, by establishing a set of principles that could be used to guide the Government and its policy advisers in the formation of tax policy. It is recognised that the Government has to strike a balance between competing objectives, like equity, simplicity, revenue collection and efficiency, in setting its policy. However, the existence of these principles would at least mean that consideration is given to risk issues in a systematic and cognitive manner in determining the balance finally adopted.

The need for reform of this nature is compelling, as problems are already emerging in its absence.

Example 3 Taxation of Financial Arrangements - Issues Paper

The characteristics of risk, and associated principles, can be used in the design of the tax system to improve its efficiency. Chapter 15 of the TOFA Issues Paper could be significantly improved by adopting this approach.

The ATO and the Department of Treasury jointly released an issues paper, Taxation of Financial Arrangements, in December 1996, that considered the tax arrangements for financial transactions. Chapter 15 of the Issues Paper was devoted to the tax treatment of synthetic replication of economic risk positions and it illustrates the problems that can emerge when there is a failure to set high-level principles for the taxation of risk.

The paper correctly states that ‘synthetic replication is effectively a form of risk transference’ (Paragraph 15.6). It goes on to propose that there be a deemed disposition of an asset where a tax payer enters into an arrangement that substantially removes the opportunities of gain and loss from the asset. This would crystallise a capital gains tax liability.

Logic suggests that if there is a deemed disposal for capital gains tax purposes, then, on the other side, there must be a deemed acquisition with a new capital gains cost base. However, the paper takes an asymmetric view by looking only to the revenue side. Therefore, it does not propose to create a notional capital gains tax cost base for deemed acquisitions that would naturally compensate for the loss of indexation by the deemed disposer.

The entity that acquires the risk (from the deemed disposer) is compensated by the income associated with this risk. The Issues Paper proposes that if the risk is acquired through a derivatives transaction, then it would be taxed on a mark-to-market, or revenue basis. Therefore, the tax revenue base associated with that risk is secure, notwithstanding the hedging of the asset. In other words, it is not necessary to have a deemed disposal of the asset.

However, as in example 2, the Issues Paper fails to acknowledge that when risk is transferred so is the income that is derived from it and there is something of a black-hole for risk. Recognition of this factor would obviate the need to look towards deemed disposal of securities to secure the aggregate revenue base, as the future income from risk associated with the asset would remain within the tax net and would be taxed on a revenue basis. This would maintain the integrity of the tax base.

There are additional problems with the approach adopted in the Issues Paper. For example, market risk may be hedged but not credit risk and the latter can have a significant impact on realised returns. Also, delineating risk in the manner required within an actively traded portfolio would be very difficult.

This illustrates the need to consider practical limitations in the design and administration of tax arrangements. For example, the proposal in the Issues Paper requires the term ‘substantial removal of risk’ to be defined but this is a very difficult task, as example 2 above demonstrates.

Fortunately, it is possible to build on the characteristics of risk to short-circuit this problem. Because income associated with risk transfers with it, risk transfer does not automatically compromise tax revenue and, as illustrated above, it is generally not necessary to seek a deemed disposal to preserve the tax base. In short, by adopting some simple principles to guide the tax treatment of risk, it is possible to improve the efficiency of tax law and lower compliance costs, while maintaining the integrity of the tax base.


3. Principles to Guide the Tax Treatment of Risk

The examples discussed in Section 2 share some important common themes, of which the principal one is an asymmetric view of risk. In order to avoid incorrect and inconsistent policy, it is necessary to define a set of high level policy principles to guide the formulation of tax policy in relation to risk and the administration of the tax law. Indeed, significant efficiencies in the administration of the tax law can be secured if an appropriate set of principles is adopted.

These principles would be set independently of any individual tax situation. It is apparent that policy formed around the prejudices of a particular conflict or difference does not serve well to set a broad framework for the taxation of risk. The principles may not exclusively determine a particular tax policy, but they would feed into the decision making process and gibe a better balance to policy.

The process of establishing a set of principles for the tax treatment of risk may seem a little daunting. However, in practice it is not so difficult and can be distilled into one overriding principle;

In general, risk transfer can be safely ignored as a criteria for determining tax liabilities and offsetting entitlements.

Better identification and pricing of risk have made economic entities more sensitive to the impact of risk on their profitability. Consequently, investors typically will not accept risk unless they are adequately compensated for holding it. Because the holders of risk must be compensated, the income associated with any particular risk travels with risk and this feature can be used as a valuable input to the design of an efficient tax system.

3.1 Why Risk can be Safely Ignored, In General.

Risk transfer is predicated on commercial considerations. It is the exception rather than the norm that risk management autonomously influences the tax outcome of a transaction, or indeed that risk management is undertaken for tax reasons. In other words, risk management has a naturally neutral impact on tax revenue and should not be directly linked with tax avoidance.

Risk is bought and sold for a price, which means that transfer of risk involves a transfer of income – even though the price may often be embedded in transaction costs and impossible to separately identify. For example, when an investor hedges their portfolio, they effectively sell their market risk to the hedge provider (while, at the same time, taking on other risks). The hedge provider receives a return for assuming this risk and must pay tax on its income from these returns. In other words, risk does not disappear when hedging takes place, but rather is only transferred elsewhere in the system, at which point it is subject to tax. This attribute of risk is not always recognised in tax policy and law, as illustrated in examples 1 and 2 in Section 2.

The real threat to the tax revenue base is that risk (and the associated income) will be transferred to an entity that is outside of the tax system with the intention of avoiding tax or generating tax benefits unintended by the Government. This identifies the potential areas for leakage and the area in which the authorities should concentrate their anti-avoidance effort, though in doing so they should not disrupt normal trade in financial services.

This provides a policy basis for measures to restrict the transfer of tax benefits to tax exempt entities. Thus, there is sound policy rationale for many revenue protection measures that are already in place. In these instances, the real challenge is to improve the design and administration of the measures.

In this context, it is important to note that care should be taken not to impede international trade in financial services, even though it frequently involves the cross-border transfer of financial risk and its associated income. This trade is entirely legitimate from a taxation perspective and should not be impeded by taxation measures. Imported financial services involve the transfer of income offshore, while financial service exports increase the income (and tax revenue) base in Australia. Measures that interfere with international trade would conflict with the Government’s policy objective of liberalising trade in services and conflict with our international obligations arising from GATS, APEC and double taxation agreements.

    1. Why Using Risk as a Tax Criterion is Fraught with Difficulty

To use risk as a tax criterion, it would need to be precisely defined – a very difficult task.

Before basing tax policy on a concept of risk, it would be necessary to define with a fair degree of precision what is meant by risk. Such a definition has proved elusive to the tax authorities to date and is likely to remain so.

Defining risk is not a simple matter as entities within and outside the financial sector have markedly different perceptions of risk. For example, financial system regulators take a much wider view of risk than do the tax authorities. Further, entities will modify their behaviour to reflect their perception of risk, so measures (including tax) that alter the risk balance can have secondary consequences that should be taken into account to the extent that it is reasonably possible.

There are many dimensions to risk, apart from market risk that has been the focus of some recent tax developments. The following list is not exhaustive and the explanations are rather cursory, but it serves to illustrate the point.

  • Market risk – profit or loss generated by a change in asset prices (different subcategories exist here, for example, basis risk and volatility risk)
  • Operational/control risk – for example, computer systems failure
  • Legal risk – potential for change to the accepted legal character of a transaction; for example, by a new court ruling or legal opinion
  • Liquidity risk – risk that contracts cannot be readily unwound
  • Counterpary/credit risk – risk of default, or delayed payment
  • Pricing risk – risk that product is systematically mis-priced
  • Reputation risk – risk that good commercial or regulatory standing of entity may be compromised
  • Systematic risk – risk associated with factors affecting the whole market
  • Asset/specific risk – idiosyncratic risk associated with a single asset.

There is also a question as to whether risk is objective or subjective risk. The latter can be particularly difficult to take account of in measuring risk against benchmarks. Which dimension of risk is most significant usually depends on the characteristic of the asset or transaction being assessed, though in general market risk is important. Typically, banks’ business encompasses each of these risk facets to some degree.

Risk is probabilistic and typically forward-looking, which means that ex post analysis of transactions must carefully conducted. For example, because the depreciation claw back provisions in the TLAB 4 Division 243 provisions, discussed in Section 1, are based on an ex post analysis of the underlying transaction, they produce an outcome that is at odds with the commercial reality of the situation.

The tax authorities do not appear to have rigorously considered the definition of risk and do not seem to have a clear view of what constitutes risk for taxation purposes. However, it is reasonable to expect that firm guidance would be given by the authorities on the factors that they will consider to be pertinent in their assessment of risk, if it were to be used as a criteria in the taxation of commercial arrangements.

In practice, the multifaceted character of risk means that its key attributes will vary from situation to situation and it will be difficult to pin down for tax purposes, leading to considerable complexity. Certainly, the standardisation sough in the Review’s legislative design principles would be hard to achieve (as the examples in Section 2 illustrate). Because of this, the ability to generally ignore risk for taxation purposes can be used to greatly improve the efficiency of the tax system.

Risk, as defined, would need to be measurable

If tax assessments were to be predicated on risk then the risk concept adopted would need to be measurable to enable taxpayers to determine tax liabilities and for the ATO to assess taxpayer compliance. In practice, this is a demanding standard that would rarely be reached with universal agreement. Risk measurement is complex science and forms a very difficult base from which to try and implement and administer tax provisions with an acceptable degree of integrity.

Banks and other entities must be able to assess and manage risk as part of their normal business. However, the methods they employ are not uniform and form part of their competitive armoury. They use measures for certain aspects of risk in transactions (for example, duration and price volatility), rather than for risk in total because its various components (market risk, operational risk, legal risk etc) are not all reliably measurable nor are they additive. Similarly, the ‘economic risk’ factor that is being drawn into tax policy is a composite measure of the various types of risk and, as such, is not reliably measurable.

Perhaps one of the more difficult facets of risk to get to grips with is its subjectivity – given the same set of information, different entities may draw different conclusions regarding risk. For example, a 1995 Bank of England survey of OTC options and swaps pricing by 40 banks and securities houses using the same input data uncovered substantial differences in the prices quoted. This highlights the need to look beyond the basic building blocks of financial engineering, like the simple but oft-quoted put-call parity relationship for options, in assessing the risk attributes of any particular transaction.

Even apparently straightforward hedging relationships can be become quite complicated. For example, hedging tends to address market risk only, leaving other risks unchanged and creating new risks, like hedge counterparty credit risk. It can even be difficult to determine if a hedge is in place; for example, a hedge usually depends on a defined correlation with an asset, but the correlation factor could systematically change over time. Further, hedges themselves are risky and sometimes fail – that is the ex ante assumed relationship between the underlying asset and the hedge instrument is found not to exist ex post. This problem could plague the ongoing implementation of risk based tests for the receipt or denial of franking credits, discussed above.

3.3 Why Taxing Risk Management should be Avoided

Recent Treasury analysis of the tax and regulatory implications of derivative risk management products emphasise their role in replicating transactions in the underlying asset. This approach is valid but only to a point; it is important to realise that derivatives also provide significant benefits that are unique to them. For example, interest rate swaps effectively overcome debtor-creditor relationship difficulties in the corporate bond market in a manner that cannot be replicated by corporate bond transactions alone and futures provide substantial transaction cost savings for portfolios.

For policy design to be effective, its formulation and implementation must embody a keen understanding of the role of risk management and appreciation of the economic benefits that it provides. The following broad points, amongst others, should be considered:

  • Risk management and trading helps to identify and evaluate risk – this results in a superior capital allocation;
  • It stimulates better distribution of risk between provider of funds and risk taker – better capital allocation;
  • It encourages risk sharing, which supports greater innovation and economic growth.

Examples of benefits to business from risk management include:

  • Allows companies to concentrate on their core business activity;
  • Reduced cost of funds (the value of this is often overstated);
  • Hedging also helps preserve smooth dividend payments, which companies and investors seem to prefer;
  • Hedging smooths income flows.

Consider the simple example of an importer with future foreign exchange expenses, who buys foreign exchange on the forward market from an exporter who has future foreign exchange receipts. In doing so, both eliminate their exposure to unfavourable exchange rate movements and benefit from greater certainty, at the cost of foregoing potential benefits from favourable movements. In short, risk is transferred to those entities most willing to hold it at a price determined in the market.

Table 1.

Trading of OTC Derivative Products in Australia by Counterparty

Year to mid-1996

Interest Rate Products


$ billion








& other %







Interest rate swaps






Cross currency swaps






Interest rate options
















Foreign Exchange Products









Domestic Dealers %

Overseas Banks



& other %

Outright forwards










Source: Figures are derived from the 1996 Australian Financial Markets Report, AFMA, Sydney (1996). Foreign exchange figures therein are derived from Reserve Bank of Australia data.

Risk management cannot permanently eliminate risk. However, the optimal time profile of hedging minimises adjustment costs to transitory shocks and, at the same time, facilitates adjustment to long term changes. This minimises capital write-off and increases the effective life of the economy’s aggregate capital stock.

Derivatives are widely used by participants in the financial sector, the corporate sector and government (see table 1), reflecting the benefits that they provide. Resources placed into the management of risk have increased significantly in Australia over the last ten to fifteen years. This partly reflects the effects of financial deregulation and the internationalisation of the economy, which increased the exposure base for financial risk and significantly increased market risk.

Australian manufacturers and service companies have a distinct advantage over their counterparts in most countries in the Asia-Pacific region, who do not have access to the range of low cost, efficient financial hedging facilities of the type available here.

3.4 A Subsidiary Principle - Taxation Should Favour Risk Management

It follows from the above discussion that efficient markets that facilitate the trading and management of risk are of significant benefit to participants in the financial sector and the wider economy. Therefore, it should be a tax policy design objective to encourage efficient transfer or risk, not merely be neutral.

Currently, the main risk is that there will be an undue focus on risk transfer based on a false premise, as there has been in recent tax measures. For instance, some have expressed the view that tax benefits (loosely defined) to a transaction should only be available to an entity directly at risk in the transaction. For example, if a tax payer ‘shelters’ behind a limited liability company, the tax benefit should only be available to the company and should be clawed back when it is passed through to the underlying owner.

The reasoning that underpins this assertion is faulty and it fails to appreciate the nature of risk. Suppose a limited liability company structure is adopted for a business activity. If the company has 100% equity funding, then the company carries the full business risk and the shareholders should be entitled to all tax benefits generated by the company. If the company has some debt, which is the normal situation, then its lenders take part of the business risk because of its limited liability attribute. In this case, the company’s lenders will seek compensation for taking that risk through the terms charged for their credit.

In other words, there is no proverbial ‘free lunch’ and any tax benefits associated with the company’s activity are earned. Failure to allow the benefits to pass through to the company’s shareholders would penalise them for, as company owners, the market has already charged them for its higher risk status (that is, their ‘shelter’). This would be consistent with an integration of ownership interests, where entities are considered as extensions of their ultimate owners – a concept endorsed by the Review. The proposed full imputation system would conflict with this, it embraced a full symmetrical integration of income and capital gains tax.

It follows that if a tax benefit is attached to a certain activity then, so long as that activity actually takes place, it should not matter who receives the benefit for tax purposes. Indeed, if the tax benefit is not tradeable, it may limit the attractiveness of the underlying tax measure and possibly conflict with its policy objective.

As in the examples discussed in Section 2, the view that depreciation and other tax ‘benefits’ should be quarantined to the entity itself derives from a misguided and asymmetric view of risk, that sees the income associated disappear down a black hole when it is transferred. It is not clear why the Government would want to follow this approach and inhibit the distribution of company earnings in a commercial manner, or in other words, why it would want to deny the pass-through benefits to the underlying shareholders.

Limited liability companies and other forms of communal investment are vital instruments for economic development and growth and it would be foolish to discriminate against them through the tax system. Similarly, it would be damaging to formulate tax policy without due consideration to the character of risk, given its central place in all economic activity.


4. Concluding Comments on Risk

The intention of the analysis here is to demonstrate the need to attach a high priority to the correct treatment of risk, when formulating tax policy. Recent tax developments indicate that there are weaknesses in the current tax system in this regard. The Review can play an important role in rectifying this situation and provide a better basis for future tax development by including amongst its principles for taxation, guidance for the correct tax treatment of risk.

Fortunately, the characteristics of risk are such that it is not necessary to complicate the tax system to take proper account of it. Because income associated with risk travels with it, in general, it is unnecessary to track the transfer of risk within the economy for tax purposes. The exceptions should be treated as such and tax measures to address them should not interfere with normal risk transfer and management activities.

The treatment of tax-exempt entities and non-residents may need special consideration in the unusual circumstances where tax benefits can be traded in a manner unintended by the Government. By the same token, care must be exercised not to interfere with legitimate domestic and international trade in financial services that involve risk transfer.

Misunderstanding of risk and a misguided tax response has greatly increased the complexity of the tax system in some areas, like the franking credit system. There was a revenue benefit for the Government from the 1997 Budget measures, however, this was at the cost of a less efficient tax system and the imposition of a flawed policy. Unless a more informed approach to risk is taken, there is likely to be additional unnecessary complexities, such the proposed claw back of depreciation on limited recourse loans.




Risk Management and Tax Neutrality – 1997 Franking Credit Measures

The example in the box below is constructed around a simplified model in which equity provides a relatively higher average return than debt, because it entails higher risk.

On average debt is assumed to return 7% and equity 10%. Therefore, the equity risk premium is 3%. When the shareholder hedges, they sell their equity risk to the hedge provider and receive a debt equivalent return averaging 7%. Meanwhile, the hedge provider will receive an average return of 3% on the risk that they have assumed.

Under the pre-Budget regime, total tax returns are 47% of the underlying company income stream, whether the share investment is hedged or not. Therefore, hedging has no inherent impact on tax revenue.

Under the Budget measures, the effective rate of tax on the underlying income stream is 66%, reflecting double taxation. The shareholder loses their franking credit because their share portfolio is hedged within 45 days and the hedge provider does not receive the franking credits.


Revenue under Pre and Post-Budget Conditions


Assume Shareholders have a 47% marginal tax rate, 100% franking credits

and a Dividend of 100.


100% Hedge is taken within 45 days.


Average Returns







Implied Equity Risk Premium



Corporate tax

Personal income tax

Total tax paid


No hedge




Company (Co)




Shareholder tax


11 on Co’s dividend


Hedge Pre-Budget








Shareholder tax


11 on Co’s dividend less 14.1 loss on hedge


Hedge provider (HP)




Hedge provider shareholder


3.3 on HP’s dividend


Hedge Post-Budget








Shareholder tax


30.1 on Co’s dividend less 14.1 loss on hedge


Hedge provider




Hedge provider shareholder


3.3 on HP’s dividend




The International Banks and Securities Association of Australia

IBSA represents and promotes the interests of investment banks engaged in wholesale banking, securities and financial markets business.

List of members:

24 November 1998 - 45 Members

ABN AMRO Australia Limited

ANZ Investment Bank

Banca Commerciale Italiana SPA

Bank of America NT & SA - Australia

Bank of China

Bank of Tokyo-Mitsubishi Australia Ltd

Bankers Trust Australia Limited

BBL Australia Limited

BNP Pacific (Australia) Limited

BOS International (Australia) Limited

Citibank Limited

Credit Agricole Indosuez Australia Limited

Credit Lyonnais Australia Limited

Credit Suisse First Boston Australia Securities Limited

Deutsche Bank Group - Australia

Dresdner Bank AG

Fuji International Finance (Australia) Limited

IBJ Australia Bank Limited

ING Bank N.V - Sydney Branch

KBC Financial Services Limited

Macquarie Bank Limited

Merrill Lynch Australasia

Morgan Guaranty Trust Company of New York

Morgan Stanley Australia Limited

N M Rothschild & Sons (Australia) Limited


Ord Minnett Group Limited

Overseas Union Bank Limited

Rabo Australia Limited

RMB Australia Limited

Royal Bank of Canada

Salomon Smith Barney

Sanwa Australia Limited

Schroders Australia

Societe Generale Australia Limited

Standard Chartered Bank Australia Limited

State Street Bank and Trust Company - Sydney Branch

Sumitomo International Finance Australia Limited

The Chase Manhattan Bank

The Dai-Ichi Kangyo Bank Limited - Sydney Branch

The First National Bank of Chicago

Tokai Australia Finance Corporation Limited

United Overseas Bank Limited - Sydney Branch

Warburg Dillon Read Australia Limited

WestLB - Sydney Branch