Journal of Australian Taxation
|
|
Home
| Databases
| WorldLII
| Search
| Feedback
Journal of Australian Taxation |
|
THE /TAX VALUE AND CONSISTENT ENTITY REGIMES: AN OVERVIEW OF THE DRAFT BILL
By Associate Professor Stephen Barkoczy[*]
The cashflow/tax value and consistent entity recommendations of the Review of Business Taxation, if implemented, will radically change the face of the Australian income tax system. This article examines the key features of these regimes in the context of the Draft Bill which accompanied the Review's Report.
As part of its platform at the last Federal election, the Government foreshadowed major policy reforms to the Australian tax system in a plan titled Tax Reform – Not a New Tax – A New Tax System. When announcing these reforms, the Government indicated that it would significantly reform the business tax system. However, the Government also indicated that before proceeding with these reforms, it would first seek consultation. It has done this through the much publicised Review of Business Taxation, chaired by John Ralph AO, which issued the following three papers:[1]
• A Strong Foundation;
• A Platform for Consultation; and
• A Tax System Redesigned.
The first paper outlined basic information about deficiencies in the business tax system and discussed the foundations upon which a good business tax system should be based. The second paper contained a detailed analysis of the range of issues before the Review and canvassed various policy options. The final paper is a report that contains the Review's many recommendations for reform. The Review's recommendations were made subject to the constraints of its terms of reference which required a revenue neutral outcome. Underpinning the many recommend-actions made by the Review are three objectives: optimising economic growth, promoting equity, and promoting simplicity and certainty.
In a Press Release dated 21 September 1999,[2] the Treasurer announced that, as a "first stage" response, the Government would accept many of the recommendations contained in the report. A "second stage" response was issued on 11 November 1999,[3] in which the Treasurer indicated that a number of further recommendations would be adopted. Many of these recommendations have since been enacted.[4]
Perhaps the most radical of the Review's recommendations is the recommendation to introduce a new method for determining taxable income called the "cashflow/tax value" method. As the discussion below will reveal, this recommendation represents a "fundamental reform" to the Australian taxation system.
Another significant recommendation made by the Review is the recommendation to introduce a "consistent entity regime" which would tax companies, trusts, life insurers, co-operatives and limited partnerships in a similar manner and would provide for a consistent treatment of entity distributions.
The Government has accepted the consistent entity regime recommendation and has indicated that it will operate from 1 July 2001. The Government has also given "in principle" support for the introduction of the cashflow/tax value system[5] with a view to originally introducing it from 1 July 2001. However, the Treasurer acknowledged in a Press Release dated 7 August 2000[6] that many businesses would not be ready by this date and that there are many detailed issues that need to be resolved in developing the system. The Treasurer also acknowledged that implementation of the cashflow/tax value regime requires ongoing consultation with all sectors of the business community as well as a major education campaign for practitioners. Bearing this in mind, the Government has therefore decided to abandon the 1 July 2001 start date and accept the Review of Business Taxation's recommendation to establish a new Board of Taxation to advise on the development and implementation of the proposed system.[7]
When handing down its report, the Review also handed down a Draft Bill entitled A New Tax System (Income Tax Assessment) Bill 1999 ("Draft Bill") as a "model" to illustrate how the proposed cashflow/tax value and consistent entity regimes might operate.[8] The aim of this paper is to provide an overview of the main features of the Draft Bill and to highlight how the two regimes are proposed to interrelate. Given the lack of publications on the topic to date, this article is purposefully largely descriptive in nature and is designed to provide a concise overview of the intricate draft provisions. The article, however, also makes a number of comments and raises a number of issues about the two regimes and makes some concluding comments on the tax reform process generally.
Before proceeding with an analysis of the Draft Bill, the following two important points need to be made.
First, it is important to note that the Draft Bill is not a complete document. In particular, it states in many parts, that specific rules on various issues are still being developed. In this respect, in its present form, the Draft Bill merely provides the "skeleton" of the proposed new integrated regimes. In spite of this "limitation", the Draft Bill still represents a significant document that may well end up being a template for the future Australian income tax regime.
Second, as the cashflow/tax value system will not, in all likelihood, be introduced on 1 July 2001, the issue arises as to whether the Government will still proceed with the introduction of the consistent entity regime as from that date. As the Government has not indicated otherwise, it is presumed that it still intends to have an operational consistent entity regime from 1 July 2001. Assuming this is the case, the relevant legislation implementing the new regime will need to be significantly different from the Draft Bill version which interrelates with the cashflow/tax value regime. In particular, it will need to interrelate with the existing tax rules. However, this does not mean that the Draft Bill should therefore no longer be of significant interest to tax practitioners. Indeed, if the cashflow/tax value system is eventually introduced, the consistent entity regime provisions will have to be remodelled so that they interrelate with the cashflow/tax value provisions rather than the present tax provisions. In such a case, one expects that the legislature will introduce provisions which have a strong resemblance to those contained in the Draft Bill. Accordingly, the Draft Bill may well represent the eventual model of our tax laws, albeit not the short term version.
The other option for the Government is, of course, to abandon the 1 July 2001 introduction date for the consistent entity regime. It could, for instance, defer its introduction until such a time as the cashflow/tax value regime is introduced (or it is decided that such a reform be abandoned). Whilst it is probably unlikely that the Government would want to hold up such a major reform pending the resolution of another tentative reform, it is submitted at the end of this article that the Government should seriously consider this option.
As indicated above, the Review of Business Taxation's cashflow/tax value recommendation represents a fundamental change to the method of calculating taxable income. The key feature of this recommendation is to replace the current system of determining taxable income which is based on legal definitions such as concepts of "income" and "capital" with a system under which taxable income is determined by reference to net annual cashflows and changes in the tax value of assets.[9] The recommended framework is driven by a desire to improve "structural integrity" in the tax system. It is designed to provide "a more coherent and durable legislative basis for determining taxable income". The cashflow/tax value approach is more in line with accounting treatment and, it is argued, would remove many inconsistencies and anomalies such as the treatment of "blackhole" expenditure[10] arising under the present regime.
The cashflow/tax value system is intended to apply to resident taxpayers and to non-residents on their income and gains that are not subject to withholding tax.[11] The Review recommended that small business taxpayers[12] should be able to elect to be taxed under a "simplified tax system" so as to alleviate their compliance costs.[13] According to the Review, the three key elements of the simplified tax system are: a cash accounting regime,[14] a simplified depreciation regime[15] and a simplified trading stock regime.[16] The Draft Bill does not contain any provisions relating to the simplified tax system.
Under the cashflow/tax value regime, it is proposed that the income tax of an Australian resident will be worked out according to the following formula contained in draft s 5-10 (this formula mirrors the present income tax formula contained in s 4-10(3) of ITAA97):
Income Tax = [Taxable income x Rate(s)] – Tax offsets
The major difference between the present regime and the proposed regime stems from the way in which taxable income is calculated.[17] According to draft s 5-15, taxable income is worked out according to the following formula:
Taxable Income = Net income +/- Income tax law adjustment – Unused tax losses
As under the present system, the proposed regime contemplates the existence of tax losses. Draft Div 36 provides that a tax loss arises where the sum of a taxpayer's "net income" and "income tax law adjustment" gives rise to a negative amount.[18] The Draft Bill states that the rules for carrying forward tax losses and how they are to be applied are being developed and there is therefore presently no definition of "unused tax losses".
Underlying both the taxable income and tax loss formulas are two key concepts, namely that of "net income" (see Part 2.1 below) and "income tax law adjustment" (see Part 2.3 below). It is envisaged that if the Draft Bill eventually becomes the foundation of a new tax Act, most issues will be concerned with the operation of these concepts. From a conceptual perspective, "net income" represents the "pure" side of the taxable income formula in that this concept is largely based on accounting principles such as "receipts" and "payments" and what essentially represent balance sheet values of "assets" and "liabilities". In contrast, the "income tax law adjustment" represents the "impure" side of the taxable income formula as it takes into account special taxation principles that deviate from ordinary accounting treatment.
"Net income" is calculated according to a 6 step method statement in draft s 5-55. The effect of this method statement can be expressed in the following formula:
Net income = Receipts – Payments +/- Net change in tax value of assets and liabilities
The following points should be noted about the net income formula:
• In general, all receipts and payments fall within the formula[19] (including constructive receipts and payments[20]). The major exception to this rule is that individuals do not include their private or domestic receipts or payments.[21]
The net change in tax value of assets and liabilities is calculated as follows:
[closing tax value of assets - opening tax value of assets] - [closing tax value of liabilities - opening tax value of liabilities]
• The terms "assets" and "liabilities" are broadly based on accounting concepts. Thus, an asset is something that embodies future economic benefit[22] (eg land, buildings, plant, stock in trade and debtors) whereas a liability is a present obligation to provide future economic benefits[23] (eg a debt owed to creditors and the balance of the contributed capital account of an entity[24]). Money is not included in the calculation of net assets and a debit balance in a money account is excluded from liabilities. This is because money is already taken into account in the "receipts" and "payments" part of the net income formula.
The tax value of an asset or a liability depends on the kind of asset or liability involved. It is determined in accordance with the tables in draft s 6-40 and draft s 6-75 respectively which cross refer to other provisions of the Draft Bill. For instance, there are special rules for determining the tax value of financial assets and liabilities under draft Div 45[25]. The tax values of some of the other more important assets and liabilities are as follows:
Assets: The tax value of trading stock is the lower of its "cost" [26] or "net realisable value"[27] (unless a market value election is in force);[28] the tax value of a depreciated asset is generally its written down value;[29] the tax value of a debt is the amount the taxpayer is entitled to receive; the tax value of a membership interest in an entity[30] is the "cost" of that interest; the tax value of goodwill is either its "cost" or "nil" (where it has not been acquired from another person); and the tax value of an asset acquired from another person is its "cost".
Liabilities: The tax value of a liability to pay an amount that is due and payable is the amount of the liability; the tax value of a balance in the contributed capital account of an entity is the balance amount;[31] and the tax value of the liability that has not yet been incurred[32] is nil.
The way in which net income is calculated is illustrated by the following example.
Assume that in Year 1 Ralph buys a building for $100,000. Assuming he has not sold the building at the end of the year, the effect on his net income is zero because the payment is matched by the closing tax value of the asset. This is calculated as follows:
Net income = Receipts – Payments +/- Net Change in tax value of assets and liabilities
$0 = $0 - $100,000 + $100,000[33]
With the exception of certain financial assets, the Draft Bill does not intend to tax unrealised gains. Thus, in the above calculation, the fact that the building might be worth more or less than $100,000 at the end of the year is irrelevant as its value is brought to account at cost.
If, in Year 2, Ralph sells the building for $150,000, his net income would be calculated as follows:
Net income = Receipts – Payments +/- Net Change in tax value of assets & liabilities
$50,000 = $150,000 - 0 - $100,000[34]
Assume that in Year 3 Ralph borrows $100,000 interest free. The effect on his net income is zero because the receipt of $100,000 is matched by a liability to repay $100,000. This is reflected in the following calculation:
Net income = Receipts – Payments +/- Net Change in tax value of assets and +liabilities
$0 = $100,000 - $0 - $100,000[35]
If, in Year 4, Ralph discharges $40,000 of the debt, his net income remains a nil amount since the payment is matched by a corresponding reduction in his liability:
Net income = Receipts – Payments +/- Net Change in tax value of assets and liabilities
$0 = $0 – $40,000 + $40,000[36]
The income tax law adjustment can be a positive or negative amount and is calculated pursuant to draft s 5-90 as follows:
Income Tax Law Adjustment = Increasing Adjustments - Decreasing Adjustments
Increasing and decreasing adjustments take into account the fact that, using the present nomenclature, the tax law does not intend to provide, in effect, the equivalent of ''deductions" for all payments and does not intend to, in effect, "assess" all receipts. Broadly, increasing adjustments will typically arise in situations where deductions are not available under the current tax law for certain payments such as the payment of income tax or the payment of a dividend by a company. Decreasing adjustments will typically arise where receipts are not assessable under the current law, such as where an entity receives net exempt income or a refund of tax.
The present CGT regime has a broad application since "CGT asset" is defined widely and there are well over 30 different "CGT events". The Review has recommended[37] that the assets to which the CGT rules apply be limited to the following classes of assets:
• shares and other membership interests other than interests in partnerships (interests held before 1 July 2000 as trading stock or revenue assets are excluded);
• land and buildings not held as trading stock (if the building is subject to the new depreciation regime, only the land will qualify);
• goodwill;
• statutory licences, long term leases of land and other rights which represent a permanent disposal of an underlying asset that would be taxed on a realisation basis;
• collectables and other non-depreciable tangible assets acquired for more than $10,000 and held at least partly for private use; and
• any other asset prescribed in the Regulations.
The Draft Bill does not contain a separate CGT regime as does the current tax law. Instead, the Draft Bill takes capital gains and capital losses into account in the net income formula. This means that where CGT assets are purchased and sold, corresponding "payments" and "receipts" arise. Where the asset is acquired and disposed of in different income years, there will also be corresponding changes in the tax value of assets at the end of the particular years.
It is expected that individuals that generate capital gains will continue to enjoy the equivalent of the 50% discount on capital gains arising in relation to relevant assets held for at least 12 months[38]. It is assumed that the way in which the benefit of the discount will be obtained is via an appropriate decreasing adjustment (although the present Draft Bill is silent on this).
Under the present CGT provisions, capital losses are quarantined and can only be offset against capital gains. It is assumed that capital losses will continue to be treated in a similar fashion under the new system (although the Draft Bill does not specify how this will be precisely achieved).
Draft Div 40 contains a uniform capital allowance regime which brings together the depreciation rules and many other capital allowance amortisation rules presently contained in the existing tax law.[39] The uniform capital allowance regime clearly provides a more simplified framework for writing-off the cost of assets. The key features of the proposed regime are outlined below:
▪ Assets will no longer need to be plant or otherwise fall within a specific head of capital allowance to be taken into account in the tax formula[40] The effect of this is that blackhole expenditure that creates or improves an asset will be written off based on effective life (ie it will fall within the standardised capital allowance regime).[41]
▪ In accordance with the depreciation changes announced in the Government's first stage response to the Review's recommendations,[42] the uniform capital allowance regime will be based on effective life write-offs.[43] Taxpayers will continue to be able to use their own or the Commissioner's valuations. They will be able to recalculate effective life where the original estimate is no longer accurate.[44] The entitlement to write-offs will lie with the taxpayer that incurs the loss in value, not necessarily the legal owner of the asset.[45]
▪ Depreciation of an asset is taken into account in the "net change in tax value of assets" part of the "net income" formula since the opening and closing tax value of a depreciated asset is based on its written down value as calculated under Div 40 at the relevant time.[46] As is the case under the present depreciation regime, taxpayers will be able to choose to depreciate an asset using either the "prime cost" or "diminishing value" methods.[47]
The aim of the consistent entity regime is to improve integrity and fairness through a single set of rules which will provide consistent tax treatment of profits earned by specified entities (companies, trusts, life insurers, co-operatives and limited partnerships). It is intended that the profits of all these entities will be subject to the same overall level of taxation and that an imputation system (which the Draft Bill states is being developed[48]) will operate. Likewise, the proposed regime aims to take consistent account of all amounts contributed to a tax entity and the return by an entity of such amounts to its members. The consistent entity regime will not apply to complying superannuation funds, complying approved deposit funds, and pooled superannuation trusts,[49] deceased estates (within 2 years of administration)[50] and excluded trusts.[51] Special rules apply to "collective investment vehicles" ("CIVs") (see Part 4 below).
The Draft Bill contains special rules relating to "distributions" made by tax entities to their "members".[52] Broadly, as under the current regime, a distribution of profits will be subject to tax in the member's hands whereas a return of contributed capital will not. Distributions of profits are "taxable" to members because they constitute "receipts" and therefore fall within the net income formula.[53] Distributions of contributed capital to members also constitute receipts but are offset by a corresponding reduction in the member's tax value of assets (ie the member's membership interest in the entity).[54]
From an entity's point of view a distribution constitutes a "payment". In the case of a distribution of profits, this payment is usually offset by an "increasing adjustment".[55] In the case of a distribution of contributed capital, there is no increasing adjustment[56] although there is usually a corresponding decrease in the tax value of the entity's liabilities constituted by its contributed capital account.[57] The consequence of these rules is that distributions have no effect on an entity's taxable income. This reflects the position under the present law.
Under the Draft Bill, a "distribution" is defined widely as the giving of a "benefit"[58] by an entity to a member[59] (or to a member's associate[60]) because the person is a member of the entity.[61] The definition is further extended to cover the provision of certain indirect benefits provided to members and their associates.[62] A distribution does not, however, arise where: market value (or greater) consideration is provided for the benefit;[63] the benefit is provided by way of a "proportionate rearrangement of membership interests";[64] the benefit is consideration for an on-market buy-back;[65] or a right to receive a distribution comes into existence.[66] Furthermore, in its second stage response, the Government indicated that it would introduce a de minimis exception to the wide distribution rule so as to exclude from taxable distributions, benefits that are no more than "incidental" to the proper administration or operation of the entity.[67]
To counter potential tax deferral arrangements under which non-taxable capital is paid to members ahead of taxable profits, the Draft Bill contains a "profits first rule". This rule ensures that "distributions" made to "members" are treated as having been first paid out of "available profits"[68] and it is only once profits are exhausted that distributions are treated as having been paid out of "contributed capital"[69]
There are a number of exceptions to the profits first rule. The most important of these is contained in draft s 154-15[70] and arises where a taxpayer's membership interests are terminated (otherwise than by rearrangement of those interests). This situation would arise, for instance, where a company is dissolved and a liquidator makes a final distribution,[71] or where a capital reduction or an off-market buy back takes place and the shareholder's shares are cancelled. Where a membership interest is terminated the "slice rule" applies.[72]
Under the slice rule, a distribution relating to the cancellation of an interest is dealt with in accordance with draft s 154-90 which contains a six step method statement.[73] The slice rule divides the distribution relating to the cancellation of a membership interest into components of, respectively, contributed capital and taxed and untaxed profits. Where the distribution is less than or equal to the interest's share of the contributed capital,[74] the distribution is deemed to be entirely from contributed capital. If the distribution is greater than the interest's share of contributed capital, the distribution is treated as being from contributed capital to the extent of the interest's share of the contributed capital and from available profits to the extent of the excess. Where some of the distribution is attributable to available profits, it is necessary to calculate the taxed profit component.[75] The distribution is treated as being wholly from taxed profits if the distribution from available profits is less than or equal to the taxed profit component. If the distribution from available profits is greater than the taxed profit component, the distribution is from taxed profits to the extent of the taxed profit component and from untaxed profits to the extent of the excess.
The way in which the profits first and slice rules operate is illustrated in the following example.
In Year 1, an entity is incorporated by its sole member subscribing for $100 of shares. The entity trades and at the end of that year it has derived $100. At the end of the year, the entity distributes $80 to its member. The profits first rule would treat this amount as coming entirely from profits. The taxable income position of the entity and member are as follows:
Entity's position:
Taxable income = Receipts – Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
$100 = $200[76]- $80[77]- $100[78]+ $80[79]- nil
Member's position:
Taxable income = Receipts – Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
$80 = $80[80] - $100[81]+ 100[82] + nil + nil
If in Year 2, the entity makes a further distribution of $50, this distribution is taken to be made from available profits (to the extent of $20) and contributed capital (to the extent of $30). The taxable income position of the entity and member are as follows:
Entity's position:
Taxable income = Receipts – Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
Nil = nil - $50[83]+ $30[84] + $20[85] - nil
Member's position:
Taxable income = Receipts – Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
$20 = $50[86] - nil – $30[87] + nil + nil
If in Year 3, the entity is wound up, the slice rule would apply. Assuming the remaining $70 is distributed to the member, this amount would be treated as having been applied entirely against the member's interest in the contributed capital of the entity and would therefore not be taxable. The relevant positions of the entity and member are set out below.
Entity's position:
Taxable income = Receipts – Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
Nil = nil - $70[88] + $70[89] + nil – nil
Member's position:
Taxable income = Receipts - Payments +/- Net change in tax value of asset and liabilities + Income tax law adjustment – Unused tax losses
Nil = $70[90]- nil – $70[91] + nil + nil
As mentioned at Part 3, the Draft Bill contains special rules relating to CIVs. The regime relating to CIVs represents an important exception to the consistent entity regime rules. A CIV is a fixed unit trust that has an "Australian presence", has its central management and control in Australia and has at least one Australian resident trustee[92]. The entity must be either "widely held"[93] or a "registered managed investment scheme"[94] in which 75% or more of the membership interests are held by "pooled investment entities".[95] Alternatively, every member must be either a pooled investment entity, a Government body not liable to tax, or a foreign resident (other than an individual).[96] Furthermore, all membership interests in the entity must be "equivalent"[97] and its activities must be limited to "investment activities".[98] The entity must also elect to be treated as a CIV.[99]
The consistent entity rules discussed above do not apply to CIVs. Instead, their income is taxed on a flow through basis. A CIV does not have to pay tax if all of its taxable income is distributed within 2 months after the end of the year (or at least 98% of its taxable income is distributed within such period and the reason it failed to distribute the full amount was due to an error or miscalculation).[100] Any income not distributed within the specified time is taxed in the entity's hands.[101]
The flow through basis of taxation ensures that distributions from CIVs retain the same source and character in the hands of a member as if the member had received the income directly.[102] This overcomes the main disadvantage of the consistent entity regime, which is that it operates to tax the "tax preferred income"[103] of an entity in the hands of an individual. It has this effect because distributions of tax preferred income are treated as unfranked distributions. This is essentially what happens at present in relation to corporate distributions, but not other distributions (such as those made by trusts). The aim of the CIV regime is to ensure that tax preferred income earned by a CIV retains its status as it flows through to an individual investor. The CIV regime is therefore loosely based on the present trust rules that adopt a flow through approach to taxation.
The rationale behind the CIV regime is to provide small individual investors with the same opportunities to invest in a range of projects on the same basis as wealthier investors. The Review considered that it was crucial to this aim that the tax preferred status of income be maintained as it passes through a CIV to an individual investor.
It is undeniable that there are many problems with our current income tax system. One only needs to consider the many cases dealing with the income/capital distinction that have plagued the courts over the years to find inconsistencies and anomalies in the law.
A striking recent example of difficulties associated with characterisation of a receipt is found in the High Court decision in FC of T v Montgomery.[104] Although this case involved a relatively simple fact situation which one would have thought should be easily resolved, it is noteworthy that the case was decided by the slimmest of majorities. Four of the Justices of the High Court[105] concluded that the relevant amount was of an income nature, whereas the other three Justices[106] came to the opposite conclusion. Indeed, it is interesting to also note that of the four Federal Court Justices that heard the case on its way to the High Court, only one Justice had decided that the relevant amount was of an income nature.[107] Accordingly, of the 11 Justices that had heard the case, only 5 had come to the "right" outcome. This kind of result is clearly undesirable.
Proponents of the /tax value system would argue that these kinds of decisions will be avoided under the new regime and that this is a desirable outcome. However, the legislature should be cautious about discarding decades of established common law in favour of a new regime which may itself provide its own problems. One expects, for instance, that if the /tax value regime is introduced, there will be many cases concerning disputes about concepts such as "assets" and liabilities". This will therefore give rise to the evolution of a whole new body of common law, which will inevitably provide its own complexities.
It is clearly inequitable under the current law that legitimate business expenditure may not be deductible where it falls within the "blackhole" category. Why should only revenue outgoings and those capital outgoings that fall within the limited amortisation regimes existing under the present law be the only kinds of business expenditure that are taken into account in the tax formula? The /tax value regime is clearly intended to remedy this situation. Again, however, it is envisaged that issues will arise as to what kinds of expenditure form "assets" and what kinds of expenditure should be "expensed". Furthermore, questions of characterisation relating to the distinction between business and private or domestic expenditure will remain an issue under the new system.
One benefit of the /tax value regime lies in is its treatment of capital gains. Clearly, the present CGT regime is overly complex and intricate. One suspects that many would welcome the removal of the present CGT regime with its more than 30 different kinds of "CGT events" and have it replaced by a set of rules that are integrated with the rest of the tax law.
Whilst the /tax value regime represents a radical structural reform to the tax laws, it is the introduction of a consistent entity regime that is expected to result in a significant revenue impact. This is particularly because it will curtail the major benefits that trusts enjoy over companies at present. For instance, presently, the tax law operates in such a way that income flowing through a trust retains its character. Accordingly, where a trust distributes a capital gain to an individual, the individual can benefit from the CGT discount rules.[108] Likewise, the individual can offset his or her individual capital losses against the distribution as it is treated as a capital gain in the individual's hands. In contrast, under the proposed consistent entity regime, capital gains derived by a trust that is not a CIV will flow through to beneficiaries as ordinary distributions lacking any specific character. Individuals will therefore not be able to benefit from the CGT discount rules in relation to underlying gains and will not be able to offset their individual losses against these amounts.
It is also clear that the drafters of the Draft Bill had their minds squarely targeted at combating various "tax avoidance" arrangements when drafting the new distribution rules. The wide definition of "distribution" in the Draft Bill demonstrates an intention to catch within the "tax net" a wide variety of value shifts by entities to their members. Indeed, the wide definition of distribution would seem to make redundant the need for special anti-avoidance provisions like the "deemed dividend rule" presently contained in Div 7A of Pt III of the ITAA36.[109] Furthermore, the profits first rule is clearly targeted at preventing entities partaking in tax deferral and capital streaming arrangements.
A feature of the profits first rule is that it may result in inconsistencies arising between the corporate law treatment of distributions and the tax law treatment of distributions. Take, for instance, the situation where a company decides to return capital to a shareholder under s 256B of the Corporations Law without cancelling the shareholder's shares. In such a case, the profits first rule will operate and the amount returned to the shareholder will be treated as being paid out of profits to the extent that the company has available profits at the time of the capital reduction. This is the case, notwithstanding that the company has debited its contributed capital account.
Similar inconsistencies to those discussed above in relation to the profits first rule may arise as a result of the application of the slice rule. For example, if a company undertakes an off-market share buy back under the Corporations Law,[110] this results in the cancellation of its shares and the consequent application of the slice rule. The effect of the slice rule is that the purchase price paid by the company for the buy back of a share will be treated as coming from contributed capital to the extent of the cancelled share's share of the contributed capital of the company. This is the case even though the buy back may have been entirely funded from the company's profits.
It is evident from the above discussion that if the proposed reforms recommended by the Review of Business Taxation are implemented, they will radically change the face of the Australian tax system. Given the Treasurer's announcement of 7 August 2000 regarding the deferral of the /tax value system, it is not necessarily certain that the Government will proceed with the introduction of the consistent entity regime from 1 July 2001. The Draft Bill clearly demonstrates that the Reviewcontemplated that the /tax value and consistent entity regimes would interrelate. Whilst it is certainly possible for consistent entity rules to be drafted independently of /tax value rules, given that the Government apparently intends to ultimately introduce both regimes, it is hoped that it will do so contemporaneously and in "good time".
If the consistent entity regime is introduced from 1 July 2001, and the /tax value system is introduced one or two years later, there will be a "double handling" of the consistent entity provisions. This is because the provisions will need to be amended to "dovetail" with the new /tax value regime. Whilst this is not expected to necessarily involve a wholesale rewriting of the consistent entity provisions, one assumes that it would nevertheless involve substantial reworking and consequential amendments to the legislation. The rewriting of legislation causes much consternation and frustration amongst the tax profession. Much angst could therefore be avoided by delaying the introduction of the consistent entity regime until such time as the /tax value regime issue has been finally resolved.
It is highly likely that the introduction of a consistent entity regime will actually produce a "windfall" to the revenue due particularly to the operation of the profits first rule and the wide distribution rule. For this reason alone, the Government would probably be reluctant to defer its introduction. Added to this is the fact that it may be concerned that momentum might be lost if the introduction of the regime was deferred pending the resolution of the outcome of the /tax value regime. Furthermore, the fact that the political time clock is ticking away and that another election is on the horizon may also give the Government additional impetus to proceed with its original plans regarding the previously announced commencement date.
On the other hand, the Government could gain much political advantage by deferring the introduction of the consistent entity regime. There is little doubt that, given the scale of recent tax reforms such as the introduction of the GST and PAYG systems, many taxpayers would welcome a temporary reprieve from the introduction of yet another major reform.
Recent experience has highlighted important lessons about the introduction of significant pieces of new tax legislation. For instance, the Tax Law Improvement Project and the debacle surrounding the unfinished rewrite of the Income Tax Assessment Act 1936 has highlighted that it is unwise to introduce legislative reform in progressive stages over several years. Furthermore, the more than 1,000 amendments made to the GST legislation demonstrates the importance of having legislative policy clearly developed before Bills are introduced into Parliament. One hopes that the Government and the new Board of Taxation will take heed of these lessons. The success of any new legislation will ultimately depend on there being a truly independent and genuine consultation process with realistic timeframes.
Stephen Barkoczy is an Associate Professor at Monash University and a Consultant at Blake Dawson Waldron. He has contributed to several editions of various textbooks on taxation law and has authored/co-authored many journal articles. Stephen is Editor of the Journal of Australian Taxation and a member of the CCH GST Advisory Board. He also serves on various Law Institute of Victoria committees.
[*] The author wishes to thank Wayne Ngo and Associate Professor Les Nethercott from Monash University for their helpful comments on drafts of this article and John Morgan and Tim Neilson from Blake Dawson Waldron for many useful discussions. Any errors or omissions are those of the author.
[1] The papers can be accessed via the website [http://www.treasury.gov.au].
[2] Treasurer, Press Release No 58, 21 September 1999.
[3] Treasurer, Press Release No 74, 11 November 1999.
[4] Overall, most of the recommendations made by the Review have been adopted by the Government. Notably, a significant recommendation which has been rejected is the recommendation to transfer the tax liability on fringe benefits (with the exception of entertainment and car parking benefits) from employers to employees.
[5] A Consultative Committee, chaired by Dick Warburton who has since been announced as the inaugural Chair of the Board of Taxation (see below), had been established by the Government to consider the proposed system. The Committee was comprised of business representatives and members of Treasury and the ATO. In a Press Release dated 6 April 2000, the Consultative Committee recommended the implementation of the cashflow/tax value system. It also suggested that the new system should be accompanied by: a clear timetable for its phased implementation; an education and training program; and an effective Board of Taxation with a coordinating role over the consultation with business.
[6] Treasurer, Press Release No 81, 7 August 2000.
[7] The Board's activities will be supported by a secretariat provided by the Treasury.
[8] A set of Explanatory Notes accompanied the Draft Bill.
[9] See Review of Business Taxation, A Tax System Redesigned (Recommendations 4.1 to 4.24)
[10] "Blackhole expenditure" covers expenditure that is absorbed in the income earning process, but which is not deductible either on an outright basis (for example, under the general deduction provision in s 8-1 of the Income Tax Assessment Act 1997 ("ITAA97")) or on an amortised basis (for example, under the depreciation regime in Div 42 of ITAA97). It would cover capital expenditure which does not produce an asset that can otherwise be written off under one of the capital allowance regimes. Many kinds of legal expenses would fall within this category: see eg Broken Hill Theatres Pty Ltd v FC of T [1952] HCA 75; (1952) 85 CLR 423 and John Fairfax & Sons Ltd v FC of T [1959] HCA 4; (1959) 101 CLR 30.
[11] Explanatory Notes to the Draft Bill, para 3.22.
[12] Broadly, taxpayers with annual turnover under $1m, exclusive of GST.
[13] Recommendation 17.1.
[14] Recommendation 17.2.
[15] Recommendation 17.3.
[16] Recommendation 17.4.
[17] The Draft Bill states that a list of tax offsets is being developed. It is assumed that this list will reflect the current notion of tax offsets and that the new regime will not materially change this concept.
[18] As under the current loss rules, a special rule applies for calculating losses where a taxpayer has "net exempt income".
[19] An amount is specifically deemed to have been received where it is credited to a money account and an amount is deemed to have been paid where it is debited to such an account (draft s 5-60). A "money account" is broadly a bank account or similar account.
[20] Draft s 5-65.
[21] Draft s 12-10. The question of whether an outgoing should be characterised as private or domestic in nature has been considered in many deduction cases (see eg Lunney v FC of T, Hayley v FC of T [1958] HCA 5; (1958) 100 CLR 478, FC of T v Forsyth [1981] HCA 15; (1981) 148 CLR 203, Handley v FC of T [1981] HCA 16; (1981) 148 CLR 182, FC of T v Janmoor Nominees Pty Ltd 86 ATC 4681, Lodge v FC of T [1972] HCA 49; (1972) 128 CLR 171, FC of T v Faichney [1972] HCA 67; (1972) 129 CLR 38 Martin v FC of T (1984) 2 FCR 260, Jayatilake v FC of T 91 ATC 4516, FC of T v Edwards 94 ATC 4255, FC of T v Cooper 91 ATC 4296, Mansfiled v FC of T 96 ATC 4001 and Payne v FC of T 99 ATC 4391). If the proposed regime is introduced, it is expected that this body of common law will remain relevant.
[22] Draft s 6-15(1). The obligation need not be legally binding: draft s 6-20(2).
[23] Draft s 6-20(1).
[24] Draft s 6-20(3).
[25] Broadly, the Division aims to tax gains or losses on financial assets that are "certain" on an accruals basis by reference to the return on the asset. The return on the asset is measured by reference to any regular coupon or interest payments, any discount or premium, or any index linked return. See further, D Boccabella, "Proposed Cashflow/Tax Value Method of Determining Taxable Income: Structure and Application" (2000) 2 Journal of Australian Taxation 82.
[26] Cost is calculated according to tables in draft s 6-105 and s 6-110: draft s 6-100. In the simplest case, the cost of an asset comprises the acquisition price and any expenditure incurred in improving the asset. It specifically does not include, for example, maintenance, repair, insurance and interest costs or rates and land tax: s draft 6-115.
[27] ie estimated proceeds of sale less costs of completion and costs of selling.
[28] See draft Div 38.
[29] See draft Div 40.
[30] Eg a share in a company. See further the discussion of membership interest in note 41.
[31] See also draft s 152-10.
[32] For example an employee's entitlement to accrued leave (see: FC of T v James Flood Pty Ltd [1953] HCA 65; (1953) 88 CLR 492 and Nilsen Development Laboratories Pty Ltd v FC of T (1981) 144 CLR 616).
[33] The net change in the tax value of Ralph's assets is calculated as follows: closing tax value of assets ($100,000) - opening tax value of assets ($0).
[34] The net change in the tax value of Ralph's assets is calculated as follows: closing tax value of assets ($0) - opening tax value of assets ($100,000).
[35] This net change in the tax value of Ralph's liabilities is calculated as follows: closing tax value of liabilities ($100,000) - opening tax value of liabilities (0).
[36] This net change in the tax value of Ralph's liabilities is calculated as follows: closing tax value of liabilities ($60,000) - opening tax value of liabilities ($100,000).
[37] Recommendation 4.10.
[38] See Div 115 of the Income Tax Assessment Act 1997.
[39] Well over 30 capital allowance regimes presently exist under the current tax law.
[40] Draft Div 40 applies to "depreciating assets", namely any asset that has a limited useful life except those assets that are specifically excluded such as trading stock (see draft Div 38) and financial assets (see Draft Div 45): Draft s 40-15. The Draft Bill provides for a separate Division (draft Div 43) to deal with capital works. The Draft Bill indicates that this Division will be substantially the same as present Div 43 of ITAA97.
[41] Blackhole expenditure that neither creates nor improves an asset will be "expensed" as it represents a "payment".
[42] Treasurer, Press Release No 58, 21 September 1999, Attachment B.
[43] Draft s 40-55.
[44] Draft s 40-60.
[45] For example, it is the lessee under a hire purchase arrangement that would be entitled to depreciation rather than the owner of the asset: draft s 6-15.
[46] Draft s 6-40.
[47] The Draft Bill provides for an irrevocable choice mechanism which reflects the position under the present law: draft s 40-50.
[48] See draft Div 156.
[49] Draft s 151-10(1).
[50] Draft s 151(2). The Commissioner will be able to extend the two year period: draft s 151(3).
[51] The Draft Bill states that rules are being developed to identify the kinds of trusts that will be excluded. The Explanatory Notes to the Draft Bill suggest (at para 13.16) that trusts that have been created or settled only as a legal requirement or subject to a legal sanction will be excluded. The Explanatory Notes go on to indicate that, for practical reasons, certain other trusts will also be excluded. These include trusts for an absolutely entitled beneficiary, constructive trusts, bank accounts of minors and short-term stakeholder arrangements. See also draft s 960-105.
[52] A person is a member of a tax entity if he or she or it holds a "membership interest" in the entity: draft s 960-115 "Membership interest" is defined in draft s 960-120 and includes a share in a company, a beneficial interest in an asset of a trust estate, an interest as a discretionary object of a non-fixed trust and an interest of a partner in a limited partnership.
[53] Draft s 153-5.
[54] The tax value of a membership interest cannot be reduced below a "nil" amount. As a result, any distribution made after the tax value of such an interest is reduced to "nil" will be taxable. This is consistent with the present CGT rule in s 104-35 of ITAA97.
[55] Draft s 152-5.
[56] Draft s 152-5(2).
[57] Draft s 6-20(3).
[58] A "benefit" would cover things such as the payment of money, the giving of discounts on goods or services by the entity and the reduction of a liability. If the benefit is money, the amount of the distribution will be the amount of money less any consideration provided for it: draft s 960-165(1)(a). Otherwise, the amount of the distribution will be the fair market value of the benefit less any consideration provided for it: Draft s 960-165(1)(b).
[59] Including a former or potential future member: s 960-135(1).
[60] Draft s 960-135(2). Where such a distribution arises, to avoid double taxation, the member is taken not to have also received a distribution: draft s 960-150(6).
[61] Draft s 960-130.
[62] Draft s 960-140.
[63] Draft s 960-150(2). This is because there has been no shift in value to the member.
[64] Draft s 960-150(4), s 960-175 and s 960-180. This would cover share and unit "splits" and "consolidations". The reason why there is no distribution in this case is because the value of the member's interests have not increased - they have simply been rearranged.
[65] Draft s 960-150(5) and s 995-1. The consideration for an on-market buy back is not treated as a distribution because the member will not generally be aware that the consideration is being received from the entity.
[66] Draft s 960-150(7). The aim of the Draft Bill is to generally only tax distributions when they are actually or constructively received. Thus, the mere declaration of a dividend by a company will not give rise to a distribution (although the payment of the dividend will).
[67] For example, the provision of refreshments to members at an AGM.
[68] The meaning of "available profits" is defined according to a formula in draft s 154-35(1). In most cases, it will simply comprise the net market value of the entity's assets (ie the difference between the market value of the entity's assets and the amount of the entity's liabilities). This will typically be determined based on accounting records: draft s 154-35(2). According to the formula, the net market value of assets is increased by any "non-asset component of the distribution" and, to avoid double taxation, it is reduced by any "prior taxed amounts".
[69] Draft s 154-1. Broadly, contributed capital represents any payment, or transfer of an asset, to an entity for a membership interest: draft s 154-40. A "non-commercial loan" (defined in draft s 995-1) made to a "closely held entity" by a member will also be treated as contributed capital: draft s 154-40(6). A "closely held entity" is an entity that has less than 300 members, or that has more than 300 members where 20 or fewer individuals directly or indirectly hold between them 75% or more of the income or capital entitlements or voting rights: draft s 960-110 and 995-1. Entities are required to maintain contributed capital accounts and "sub accounts" for each class of membership interest: draft s 154-45. The relevant credit and debit entries and other rules relating to these accounts are contained in draft s 154-50 to s 154-80.
[70] The other exceptions are contained in draft s 154-10, s 154-20 and s 154-25.
[71] Distributions by liquidators and other external administrators of an entity are treated as if they are made by the entity: draft s 960-160.
[72] The slice rule also applies to the consideration provided for an on-market buy back (which is deemed not to be a distribution under draft s 960-150(5)): draft s 154-85.
[73] Special rules apply where a series of distributions are made in respect of a membership interest: draft s 154-90(3).
[74] This is determined under draft s 154-95.
[75] This is done in accordance with draft s 154-100.
[76] This amount represents the sum of $100 receipt of contributed capital and the $100 receipt.
[77] This amount represents the payment of the dividend.
[78] The net change in the tax value of the entity's liabilities (ie contributed capital balance: see draft s 6-20(3) and s 152-10) is calculated as follows: closing tax value of liabilities ($100) - opening tax value of liabilities (0).
[79] This increasing adjustment arises pursuant to draft s 152-5(1).
[80] This amount represents the distribution received.
[81] This amount represents the payment of contributed capital.
[82] The change in the tax value of the member's assets (ie contributed capital: draft s 6-40) is calculated as follows: closing tax value of assets ($100) - opening tax value of assets ($0).
[83] This amount represents the distribution paid.
[84] The net change in the tax value of the entity's liabilities (ie contributed capital balance: see s 6-20(3) and s 152-10) is calculated as follows: closing tax value of liabilities ($100) - opening tax value of liabilities ($70).
[85] This increasing adjustment arises pursuant to draft s 152-5(1).
[86] This amount represents the distribution received.
[87] The change in the tax value of the member's assets (ie contributed capital: draft s 6-40) is calculated as follows: closing tax value of assets ($100) - opening tax value of assets ($70).
[88] This amount represents the distribution paid.
[89] The net change in the tax value of the entity's liabilities (ie contributed capital balance: see draft s 6-20(3) and s 152-10) is calculated as follows: closing tax value of liabilities ($0) - opening tax value of liabilities ($70).
[90] This amount represents the distribution received.
[91] The change in the tax value of the member's assets (ie contributed capital: draft s 6-40) is calculated as follows: closing tax value of assets ($0) - opening tax value of assets ($70).
[92] Draft s 157-95(1)(a) to (c).
[93] Draft s 157-95(1)(d)(i). An entity is widely held where it has at least 300 members (provided 20 or fewer individuals directly or indirectly do not hold between them 75% or more of the income or capital entitlements or voting rights): draft s 960-110.
[94] A registered managed investment scheme within the meaning of the Corporations Law registered under s 601EB: draft s 995-1.
[95] A CIV, a complying superannuation fund, a complying ADF, a PST, a life insurance company, or a friendly society: Draft s 157-95(1)(d)(iii).
[96] Draft s 157-95(1)(d)(ii).
[97] Draft s 157-95(1)(e) and (3).
[98] Draft s 157-95(f). Investment activities essentially consist of passive investments such as land, shares, bonds and loans: draft s 157-95(3).
[99] Draft s 157-100 and 157-105.
[100] Draft s 157-10.
[101] Draft s 157-15.
[102] Draft s 157-40.
[103] The term "tax preferred income" loosely refers to income which enjoys various tax concessions, such as exemptions from tax in the entity's hands.
[104] 99 ATC 4749.
[105] Gaudron, Gummow, Kirby and Hayne JJ.
[106] Gleeson CJ, McHugh and Callinan JJ.
[107] See Montgomery v FC of T 97 ATC 4287 (per Jenkinson J) and 98 ATC 4120 (per Davies, Lockhart and Heerey JJ).
[108] See ITAA97, Div 115.
[109] This Division treats certain loans and payments which represent disguised distributions of profits made by private companies as dividends assessable under s 44(1) of ITAA36.
[110] See Corporations Law, Div 2 of Pt 2J.1.
AustLII:
Copyright Policy
|
Disclaimers
|
Privacy Policy
|
Feedback
URL: http://www.austlii.edu.au/au/journals/JlATax/2000/20.html